Square 1: The Basics of a 1031 Tax Exchange
Looking for ways to grow your net worth? Who would say no to that, right?! Well, if you have real estate investments, you may be interested in participating in a 1031 Tax-Deferred Exchange as a growth strategy. The 1031 Tax Exchange gets its name from Section 1031 of the United States Internal Revenue Code, which enables the avoidance of paying capital gains taxes when selling an investment property and reinvesting the proceeds from the sale into a like-kind property of equal or greater value. The transactions must be completed in a certain time period, but by deferring these taxes, it frees up more capital for investment into the replacement property, thus increasing the value of the overall portfolio. Because the 1031 Tax Exchange process is complicated, nuanced with rules and requirements, and is unique in every situation, we have outlined a few things you should know before embarking on this type of real estate transaction.
Why Is a Qualified Intermediary Important?
As determined by section 1031, if a seller receives any proceeds from the sale of a property it becomes a taxable event, and the 1031 Tax Exchange can no longer occur. A qualified intermediary will facilitate the 1031 Exchange by holding the funds from the sale of the relinquished property and transferring them to the seller of the replacement property. It is their job to ensure that timelines and guidelines are met, and that the transaction does not become taxable, so the 1031 Exchange can occur. A qualified, knowledgeable, and detail-oriented intermediary is an imperative part of the 1031 equation.
Replacement Property 101
The properties that qualify for a like-kind exchange must be actual, as further defined by the IRS in a recent regulation. What is interesting to note is that the properties (both relinquished and replacement) do not need to be in the same city or state. As well, an investor can choose to exchange one investment property for multiple replacement properties if they meet the 1031 guidelines. As long as they are purchasing three or fewer replacement properties, the value of the collective properties is more important than the actual number of properties involved in the 1031 Tax Deferred Exchange. It is possible to purchase more than three properties, but more restrictions are then applied to the transaction, which affect the overall value and must be taken into consideration.
Types of 1031 Exchanges
With the 1031 Tax Exchange, real estate investors can potentially defer capital gains taxes indefinitely if they continue to reinvest into other investment properties. In some cases, this can be up to 40% of the transaction, making the 1031 a smart growth strategy for bigger and better, and an increased portfolio value. There are quite a few different types of 1031 Exchanges that qualify for tax deferment, each with unique regulations and timeframes. A 1031 Tax Deferred Exchange professional can guide you through these in more detail, but here is an overview of exchange types:
Concurrent or Simultaneous- When the sale of the relinquished property and the purchase of the replacement property occur on the same day, the proceeds can flow directly into the purchase transaction.
Delayed- If the investment property is sold to an unrelated third party, the investor has 180 days from the sale of the relinquished property to purchase the replacement property.
Improvement Exchanges- Here an investor can utilize proceeds from the sale of the relinquished property to renovate an existing investment property that may currently be lesser in value than the original property but will likely increase its value once the work is complete. There are strict IRS requirements to this type of exchange, and it is especially important that it is facilitated by a qualified intermediary to ensure it qualifies and goes smoothly.
Construction Exchanges- With this type of exchange, the capital from the sale of the relinquished property is intended to go toward purchasing land with the intent of constructing a building on the newly acquired property. Although the actual construction is not mandated to happen within 180-days, that is the timeframe in which the entire exchange itself needs to be conducted. If the real estate investor takes title to the land at any given point, then it becomes a taxable event and can no longer be classified as a 1031 exchange.
Partial Exchange- It is ideal for the real estate investor to reinvest as much of the proceeds from the relinquished property as possible since that optimizes the growth opportunity of the 1031 by avoiding payment of the most tax. However, reinvesting the full amount of proceeds is not required, and a Partial Exchange can take place. It is important to note that the uninvested amount becomes immediately subject to taxation.
Reverse Exchange- When the investor is ready to purchase their new, or replacement like-kind property before the sale of the original property, then a Reverse Exchange transaction must be used. Since the investor cannot own both the relinquished and the replacement property at the same time, they must engage an Exchange Accommodator Titleholder (EAT) to take title to the property. Once the investor sells the relinquished property, the proceeds are used to purchase the like-kind replacement property from EAT. There are two different formats of Reverse Exchanges (First and Last) that the Intermediary will recommend, which depend on the timing of the transactions and financing.
An Expert Knows Best
As with any investment opportunity, the goal is to use what you have in order to build your wealth. A 1031 Tax Deferred Exchange is a smart strategy; however, it is not a one-size-fits-all initiative. Real estate investors are advised to engage an expert who is familiar with the market and 1031 rules, regulations, and timelines. As well as being imperative to the process in the role of a qualified intermediary, a 1031 Exchange professional will work with you to determine what is best for your situation and overall desired outcome.
Southern California Exchange Services has been helping clients strategize and optimize their real estate investments through 1031 Tax Deferred Exchanges nationwide for over 20 years. We are committed to helping our clients pursue and realize their financial goals and are ready to help you, too. If you have any questions about the 1031 Tax Exchange, or are ready to take the first step, please visit our website or reach out to us at megan@sces1031.com or 805-738-2599. We look forward to hearing from you!