Although it may seem confusing at first, the 1031 exchange is the most effective way to grow your real estate portfolio without losing a huge portion of your wealth to taxes on capital gains.
Sadly, many investors including long-time investors are clueless about how to do a 1031 exchange the easy way and they ultimately end up spending many hours trying to navigate through confusing paperwork themselves when the process is actually a lot simpler than they think.
In this article will break down the 1031 exchange and provide you with tips that you can use to grow your real estate portfolio while avoiding the specter of having to pay a ton of money in capital gains taxes.
1031 Exchange Overview
The 1031 exchange is a nickname for Section 1031 in the United States Internal Revenue Services tax cut. This section states that if an individual exchange or sells an investment property for the purpose of purchasing another investment property, they must exchange property #1 for like-kind property. This is the key to success with a 1031 exchange because, if the second property can be defined as”like kind” then the property owner may be able to defer the taxable event and avoid having to pay Capital Gains which they would normally have to pay at the time they sell property #1.
Example: If the definition of “like kind” still doesn’t make sense, we can break it down further. Let’s say that you purchase a piece of real estate for $100,000 and then ultimately sell it for $500,000. Since you’re effectively making a profit on the sale, you will have to pay Capital Gains on your $400,000 profit.
Even though every investor loves the idea of turning a profit, the reality is that the capital gains on $400,000 could amount to $100,000 to $150,000 in capital gains taxes depending upon which tax bracket you currently fall into.
Thankfully, with a 1031 exchange, the Internal Revenue Service will let you effectively defer your taxes if you use all of the proceeds from the sale of your property towards purchasing another $500,000 property. Once you purchase a new property that’s determined as “like kind” you can effectively defer having to pay capital gains taxes.
Helps Your Money Go Further
Although you ultimately will have to pay taxes at some point, you can definitely make your money work for you by utilizing a 1031 exchange.
Why Is A 1031 Exchange Important?
As we stated earlier in this article, a 1031 exchange is important because it’s going to enable you to create more wealth without taking a huge tax hit along the way. Any investor who uses a 1031 exchange throughout their career will enjoy the rewards that come when they purchase bigger and better properties.
What Properties Qualify For A 1031 Exchange?
As with many of the rules and regulations that are written by their Internal Revenue Service, the language in the tax code regarding 1031 exchanges can be vague or difficult to understand.
With a 1031 exchange when you sell one property you must purchase another property that is classified as “like kind”. The following is the specific language from the IRS website:
“Both properties must be similar enough to qualify as “like-kind.” Like-kind property is the property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to another real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”
The good news about 1031 exchanges is that even though the IRS has their classification of “like kind”, the reality is that this classification doesn’t just apply to you purchasing one property that’s similar to another. Example: purchasing one apartment building for another apartment building etc.
With a 1031 exchange, you can sell your apartment building and use proceeds from that sale to purchase land, a ranch, strip mall or any other property which is of equal value to the property which you have sold.
A word of caution: to make a 1031 exchange work, you must actually own real estate not a share in a Real Estate Investment Trust (REIT)or a real estate investment fund.
Let’s say that you exchange a cheaper or less expensive property, you will have to consider paying taxes on the price difference.
If you receive cash, relief from debt, or property that cannot be considered to be like kind, you may ultimately trigger some taxable gains in the year of the exchange. Thankfully, it’s possible to have both deferred and recognized gain in the same transaction when a taxpayer exchanges for the like-kind property of lesser value.
Subject To Time Limit
One of the most important things to know about 1031 exchanges that you have a time limit 45 days after you sell your property to identify potential replacement properties. when should identify a new property, the identification must be done in writing, signed by you, and then delivered to the individual who is involved in the sale of the like exchange property like the seller themselves, or possibly a qualified intermediary.
Besides the 45-day time limit, you have six months or 180 days or you could end up paying taxes on the entire sale of your property.
There’s no doubt that in a perfect world most investors would love to sell their property and then purchase a like time property immediately. Unfortunately, this is difficult to enact because both real estate transactions have many moving parts that are not generally known for speed. Having a transaction go quickly would require the real estate investor to find a perfect property at almost exactly the same time as when they are selling their original property. Thankfully, this is why a deferred exchange is like the 1031 exchange is allowed.
What Is A Qualified Intermediary?
How have you been thinking about using a qualified intermediary? This term applies to someone who will buy your property sell it then purchase another property on the other end of the exchange.
Utilizing such an individual ensures that the entire series of actions will remain one transaction rather than receiving taxable cash for the sale.
Also known as a 1031 accommodator, a qualified intermediary also uses a special escrow account that will hold your money so you will not have to touch it.
Besides giving you confidence that you will not have to touch the cash from the sale of your property, you could also have confidence that all documentation related to the sale will be handled by the qualified intermediary. This keeps you out of the transaction and will give you confidence that everything will be handled for you.
If you have questions about finding a qualified intermediary, you could possibly use a large title Company in your area to act as one for you since many local offices are not equipped to do it. It’s also possible to utilize a real estate attorney or certified public accountant to act as a qualified intermediary for you as well.
The cost of hiring a qualified intermediary can depend on the complexity of your situation but, for simpler deals, it’s possible that the cost could amount to just a few hundred dollars although the expense can’t get much higher if there are more complications which are involved in the overall transaction.
Tips For A Smooth 1031 Exchange
We’ve offered you a lot of tips in excellent information on 1031 exchanges so far but, before wrapping up this article would like to offer you five tips that you can use for a smooth 1031 exchange transaction.
Tip #1 – Always Sign Exchange Documents Before You Close
With 1031 exchange rules, you will be able to sell you relinquish property to a buyer and acquire replacement property within 180 days from a different seller. It’s imperative that every seller sign the exchange documents on or before the date that they close the sale of the relinquished property.
1031 exchange documents will include the exchange agreement that was entered into if the seller or real estate investor chose to hire an intermediary help process the 1031 exchange.
#2 – Think About Who Will Acquire The Replacement Property
With a 1031 exchange, the same taxpayer who sells the relinquished property most by the replacement property but, what if a lender ultimately requires the seller to acquire a replacement property that’s a single acid density? This is ultimately workable because single member limited liability company is disregarded for tax purposes so an investor can sell his relinquish property that has been held by him individually and acquire a replacement property in an LLC just as long as he is the only member or owner of that LLC.
#3 – Buy Enough Replacement Property To Defer All Gain
Remember, in order for you to completely defer all the tax that you would otherwise have to pay on the game, you have to acquire a replacement property that’s equal to or greater in value than the relinquished property. Sadly, many investors fail to do this every single year and ultimately end up paying thousands in capital gains because the replacement property is worth less than the property which they recently sold.
#4 – Don’t Forget About Expenses
As with any real estate sale, there are going to be expenses that will be required to pay but, the good news is that with 1031 exchange, the exchange proceeds can be used to pay things like brokerage commissions, exchange fees, escrow fees, and transfer fees.
One thing you cannot do though is give the buyer credit for security deposits or prepaid rent because, when you’re doing this you are essentially exchanging proceeds for the non-exchange expense and this could ultimately result in your exchange partially taxable. For this reason, it’s best for you to use your own money pay for things that you do not want to pay any tax on.
#5 – Think About Safety Of Your Funds When Using An Intermediary
If you plan on using an intermediary to do your 1031 exchange you should absolutely verify how the funds are going to be held from the sale of your property especially if they will be home in a separate account that can be identified with your name and tax ID.
The bank must also be FDIC insured and invested in securities plus they must be strong financially and have a good reputation. These are all important things to consider before utilizing an intermediary to do your 1031 exchange.
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