For those who want to avoid paying Uncle Sam his dues (taxes) in whatever legal and reasonable way possible, a 1031 exchange could be an attractive option. Should you also own investment properties, particularly ones likely to beget a hefty profit (and subsequent tax bill), a 1031 exchange could be an imperative tool in your transactions.
Defining a 1031 Exchange
Named after section 1031 of the United States Internal Revenue Code (IRC), the 1031 exchange is a method used to postpone any capital gains taxes on the sale of a property (business or investment). Often referred to as a “like-kind” exchange, it is made possible by using the proceeds to buy a similar property.
Be aware that 1031 exchanges are reserved for business and investment properties only, not personal property. Property reserved for personal use, such as your home or a vacation home, is not eligible.
Reasons to Consider a 1031 Exchange
As an investor, there are many reasons why a 1031 exchange may be attractive.
- You may have found a property that you believe has a good chance of returning a profit.
- You wish to diversify your assets.
- You are consolidating several properties into one under the pretense of estate planning, or dividing a single property into several assets.
- Turning back the depreciation clock, you elect for tax deferral rather than sell a property and then buy another property, which allows more capital to be used for investment in the new property.
Understanding capital gains, appreciation, and depreciation with regards to investment properties is key in understanding if and why a 1031 exchange may be useful.
When it is time for a property to be sold, the capital gains taxes are calculated in conjunction with the original purchase price plus any improvements made, minus any depreciation. Any amount of depreciation that has amassed since purchasing the property will now be included in the taxable income from the sale of the property. Since any depreciation that occurs is recaptured over time, executing a 1031 exchange becomes an appealing option instead of increasing taxable income.
For investors considering a 1031 exchange, depreciation recapture will always be a variable to consider in the calculations, although the extent varies case by case.
Properties That Qualify
All “like-kind” properties will qualify for a 1031 exchange. What qualifies a property as like-kind, according to the IRC, is any property held for investment, trade, or business purposes under Section 1031. Both properties involved must meet these requirements, so personal and vacation homes are not eligible.
While the properties must be located in the United States to qualify, they do not have to be of a similar grade or quality. This means that vacant land could be exchanged for commercial or vice versa, although, in order to maximize the benefit of the 1031 exchange, the replacement property should be of equal or greater value.
Theoretically, an exchange is simply a swap of one property for another between two persons. However, as many experienced investors will tell you, it is unlikely that the process will always go smoothly. Should you have the good fortune to find someone who owns the exact property you want while you simultaneously own the exact property they want, thank your lucky star.
Because of the unlikeliness of that scenario, the lion’s share of exchanges are delayed or three-party exchanges. In delayed exchanges, a qualified intermediary is needed to serve as the middleman who holds onto the cash from the sale of your property. He then uses these proceeds to buy the replacement property. The investor cannot receive the cash, as it must go to the intermediary, or else the 1031 exchange becomes null and void.
Within 45 days of the sale of the property, you must specify to the intermediary in writing, the replacement property you are seeking to purchase. According to the IRS, you can specify up to three properties to your intermediary, with the caveat that you eventually close on one of them. Under certain stipulations, you can designate more than three properties.
The only other timeline to worry about in the delayed exchange is the timing of your closing on the new property, which must be closed within 180 days of the sale of the old property. It is important to note that the two timeframes mentioned above run concurrently. For example, if you specify your replacement property 45 days after the sale, you will have 135 days to close on it.
Choosing an Intermediary
Choosing a qualified intermediary is imperative in the 1031 exchange process because the intermediary plays a pivotal role. Intermediaries are involved in the process from start to finish to ensure that the exchange goes smoothly and is not disqualified, which would leave you with an unexpected tax liability.
There is a surfeit of qualifications to look for when selecting an intermediary. Their business history and the total number of exchanges completed, particularly in recent years, are just two things to look at. If they have demonstrated substantial staying power in the industry, then that is a plus. How the funds and the proceeds are held is also something that should be taken into consideration as soon as possible.
Keep in mind that qualified intermediaries are not regulated like other financial professionals, so find out what type of insurance they have and make sure that your money and properties are protected.
Something that qualified intermediaries have in common with other financial professionals is that they do not work for free. An intermediary may be a subsidiary of a bank or a non-institutional independent professional working for themselves. Both may charge setup and administrative fees and fees related to any additional properties.
The fees and their amounts will vary depending on who you choose, so be mindful. A good rule of thumb is that the more complex the exchange, the more numerous and hefty the fees will be.
Tax Aspects to Consider
Don’t forget that the allure of the 1031 exchange is that there is no income to be taxed, as long as you do not receive any proceeds from the sale of your property. Getting your hands on proceeds from the sale before the exchange has come to fruition will likely disqualify the exchange and immediately make any capital gains taxable.
You will still be required to file forms to the IRS related to the exchange, in this case the IRS Form 8824, along with your tax return.
Tax strategy and estate planning include looking into the future, often by many decades. Bear in mind that when an exchange is executed successfully, your capital gains taxes are not forgotten, they are just postponed. Sooner or later, that tax bill will come, so be prepared for it. While capital gains rates have stayed between 15 and 20 percent since 1997, they have historically been much higher, reaching almost 30 percent in the early 90s and even higher in prior decades.
While all contingencies should be outlined when estate planning, a significant benefit of participating in a 1031 exchange is that the tax deferment can be taken to the grave.
Should your heirs inherit any property received through a 1031 exchange, the value of the property is considered to be “stepped up” to the fair market value, and subsequently erases the tax deferment debt. For example, suppose you were to die having not sold a property obtained via a 1031 exchange. In that case, your heirs and or beneficiaries inherit the property at the stepped-up market value, without having to pay the deferred taxes.
A capable estate planner should be consulted if this scenario seems plausible. An astute planner can structure assets to align with how you want them distributed after death.
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