The 1031 exchange rules can be very helpful to real estate investors. So what is the 1031 exchange you ask? In it’s most simplistic nature, it allows real estate owners to tax defer the capital gains they would have incurred from selling their property, if they utilize the proceeds to acquire a like-kind replacement property. There are additional conditions that must also be met.
Before beginning the process, it’s best if you seek the advice of a tax professional. Next, you will need to find a Qualified Intermediary to preside over the 1031 exchange. Failure to have an intermediary means the 1031 exchange is void, something which I am pretty sure you don’t want to happen. Also, your intermediary can not be your current CPA, lawyer, or real estate broker. Finally, adhere to the timelines set forth by the IRS. You must identify the replacement property within 45 days, and the property must be acquired within 180 days.
Yes, the requirements set forth under the 1031 rules are cumbersome, but when done properly it provides a great advantage to the real estate owner, and also inheritors of 1031 property (see point 5).
- They have enabled real estate owners to own multiple properties at once. The 1031 exchange can allow you as an investor to obtain additional properties without the IRS taking its cut first and depleting your cash flow. It can also help diversify your investments and spread the risk across different buildings. A good example is exchanging one large-scale hotel building with a smaller commercial office building and/or mall property located in different regions.
- The receipt and release of money is handled by the intermediary, thus allowing the owners to be relieved from the temptation of spending their proceeds. This is very advantageous for those who think everyday is Black Friday and spend like there’s no tomorrow.
- A 1031 allows you to defer paying capital gains tax. Am I beating this point to death – You Bet! This does not and should not be confused with not paying capital gains tax, as many would be tax defaulters would like to think. It just means you push forward the period you will meet the ever serious tax man you love to hate.
- It saves real estate owners from paying depreciating recapture tax at the time of the exchange, and instead pushes it forward. This means money stays in your pocket which can translate to more capital available for investments. Now if I were you, I’d be happy to get to keep more of my money.
- These rules allow heirs of real estate properties acquired through 1031 exchange to avoid paying capital gain taxes at all. How does this happen? Well, when your heirs inherit the property they get a “stepped-up” basis in the property. This means the basis is equal to the fair market value of the property at the time of your death. So how do they avoid taxes? So, if a building who has a fair market value of $1 million dollars sells for $1 million dollars, the seller would recognize $0 in gains. In contrast, if the original 1031 property owner sells the building for $1 million dollars but only had a basis of $200k, then a $800k capital gain would be recognized and taxed by the IRS.