1031 Exchange for real estate investors is often talked about, but not always understood when it makes sense.
Toija Beutler, the principal of Beutler Exchange Group LLC , has been acting as a qualified intermediary to facilitate 1031 exchanges since 1992. Following is a summary of our conversation.
What is a 1031 Exchange?
Section 1031 of the Internal Revenue Service tax code is where the law originates. The code was written in 1919, however prior to 1992, there was no regulation. A 1031 Exchange provides the seller of three types of real estate, residential rentals, commercial property and investment land. Each of these are eligible for exchange.
If a taxpayer elects to exchange one property for a like kind property, they can transfer the tax and depreciation to the new property. This transfer allows the seller to defer paying the tax normally due upon sale.
A lIke kind exchange allows the seller to sell one type of real estate and buy another. The program is an incentive for real estate investors to keep their money in real estate.
What is Deferred?
There are two benefits for the real estate investor who elects to exchange. The ability to defer both the capital gains and the depreciation recapture from the property you are selling. When you exchange from one property to another, the capital gains and depreciation recapture that would normally be due at sale, are transfered to the new property.
To complete a 1031 exchange, the rules for replacement apply to the property, equity and debt from the sale property. This means that the seller must purchase a property of equal or greater of the net value, invest all of the equity from the sale, and replace the debt that was on the sale property.
The debt on your property can be replaced with cash if you would prefer to not take new debt on your replacement property.
If the replacement property is of lesser value, does not use all of the equity nor replace all of the debt, there will be tax due from the seller.
The timeline for 1031 exchanges are carved in stone. There is no option for extension. When you sell a property, you have 180 days from the sale to complete the purchase of your replacement property. From the date of sale, you have 45 days to identify 3 potential properties to use for your replacement. Once you identify, you must complete the purchase of one of the three properties for a successful exchange.
Toija recommends that as soon as you have half a thought about selling, you should engage a 1031 accommodator. This allows you the best option to complete a successful exchange.
Questions for Consideration
What are you selling and what do you want to buy? These are some of the first questions you need to answer. How the property is titled is how the replacement property will need to be titled. If you own a property with others and the sellers are not in agreement on the replacement property, you will not be successful.
Who can you buy from? Anyone except for a related party, parents, grandparents, children, brothers and sisters are all excluded as options for you to purchase from.
Strategies for replacement property need to be considered prior to selling the first property. For the best outcome, it is advisable to have a conversation with an exchange accommodator and your tax professional to create a successful strategy.
When a 1031 Does Not Work
A 1031 exchange does not work for a second home. If twenty-four months prior to the date of sale, and 24 months after the purchase of replacement property, personal use is not allowed.
Nor is a Flip eligible for an exchange. A flip is inventory.
For a mixed use property, you can exchange the portion of the property that was used for investment.
Reverse 1031 Exchange
In a forward exchange, the qualified intermediary acts as the seller for you, then applies the proceeds in the new property. If you find a replacement property prior to completing the sale of your first property, you can utilize a Reverse Exchange. This requires that the qualified intermediary hold title of the replacement property until the first property is sold. The same 180 day timeline holds true. You must complete the sale of the first property within 180 days from the purchase of the replacement property.
Constructive receipt is what triggers the tax. When you hire a Qualified Intermediary, they take receipt of proceeds and coordinate with the title company for the placement of the proceeds. This eliminates the taxable event for you the seller.
Each week I ask my guest, “What is the Biggest Risk Real Estate Investors face?”
BIGGEST RISK: Failure to engage a 1031 Exchange Company prior to closing.
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