What You Should Know About a 1031 Exchange
A 1031 exchange can be a property investor’s best tool for making money, as long as it’s done right. Also known as a like-kind exchange, or in some cases a Starker, a 1031 exchange is an exchange of one type of investment property, real estate property, or business for another. The advantage of the 1031 exchange is that there is no tax. Essentially you are changing your investment property without paying tax or cashing out; meanwhile it continues to grow tax deferred (like a 401k). If you have more questions, please contact a team member at Calkain Companies, LLC today.
No Limit to 1031 Exchanges
Investors can engage in 1031 exchanges as many times as they wish. You can roll over the gain of one real estate property to another, and then another, and so forth. Profit could be made on each exchange, but until you sell it for cash, you don’t pay taxes. A successful 1031 exchange will need to involve a 1031 intermediary.
Repealing 1031 Exchanges
There is a lot of talk, including proposals in the government, about repealing this provision. Although it is unlikely to pass, if you’re considering a 1031 exchange, you should get started on it now to gain the benefits sooner rather than never.
Key Rules of a 1031 Exchange
A 1031 Exchange is Only For Investment Purposes
It is not possible to use a 1031 exchange on a primary residence or vacation home. You can only use it for investment and business properties. In some cases, a 1031 exchange is also used on personal property such as art. Converting a personal residence into an investment property is also possible in select scenarios. To learn more about any of these situations, please speak with a 1031 exchange intermediary.
Like-Kind May Not Mean What You Think It Means
The term ‘like-kind’ doesn’t necessarily mean the property has to be exchanged for the same kind of property. You can exchange a strip mall for an apartment building and raw land for a horse ranch.
It May Be Possible to Delay the Exchange
A classic 1031 exchange would involve a simple swap of one property for another. Some exchanges may take more than the allotted time as the process may be delayed. When these happen, you will need a third-party intermediary who will hold the cash after the sale. The intermediary then purchases the replacement property with the cash they’re holding.
Understanding Replacement Property
1031 exchanges have specific rules regarding timing. These must be adhered to in order for the 1031 exchange to work. After 45 days of the sale, you must choose a property you wish to purchase. This should be put into writing and given to your intermediary. Up to three properties can be designated, and you must close on at least one within six months. The 45 and 180 days run consecutively. After the 45 days, you have another 135 days to close on a property.
Left Over Cash is Taxable
If there is any money left over after the sale and purchase, you will receive it after the 180 days. This leftover cash is called ‘boot’ and is taxable.
When most people think about a 1031 exchange, they just imagine the tax advantages they can gain from it. However, deferred taxes are not the only advantage from this type of exchange. Let’s take a closer look at some of them:
1. Tax Benefits
As stated, one of the premier benefits of investing in net lease are the tax benefits. Within the commercial real estate realm, the most common is the 1031 Exchange, with a Section 1033 Exchange close behind. Simply, these two mechanisms allow investors to defer taxes and build wealth over time. We’ll get into the weeds a bit later, but first, let’s be clear – tax-deferred exchanges can be extremely valuable as an investor. It’s wise and highly encouraged, that in taking advantage of these measures, you consult your account. Real estate can be complicated and having an expert set of eyes on the transaction is a smart move.
2. Defer Capital Gains
1031 exchanges, or 1033 exchanges, allow you to defer capital gains tax. Capital gains are generally taxed at a preferred rate in comparison to ordinary income and it provides incentives for investors to make capital investments and to fund entrepreneurial activity. Tax amounts depend upon your tax bracket and the amount of time your investment was held before you sold it. And doing a 1031 exchange is a popular choice for investors who have land that produces little or no income, or for those who find themselves with a management-intensive building who want to rid themselves of the extra hassles.
So how does this really work? When a property is sold and a profit earned (capital gains), the government wants its share (a capital gains tax). Through the application of a 1031 or 1033 exchange, an investor is allowed to sell one property and invest into another property without incurring the capital gains tax. You must however, invest all your profits into the next property (or properties) within a specific timeline.
1033 rules are different than those for a 1031. With a 1031, a qualified intermediary is required to hold the funds during the time between original sale and replacement acquisition, whereas in a 1033 exchange, the owners are allowed to hold the proceeds themselves. A 1033 also allows more time to “find” the replacement properties, being two years versus the 45 day period in a 1031 exchange.
The 1031 is again the most popular of the two exchanges and being a government program, there are specific rules and regulations that must be followed. The main rules, are that the property must be held for investment purposes and the exchange must be for “like-kind” assets. The replacement property must be identified within 45 days, with 180 days allowed for the transaction (or closing) to actually take place. All proceeds from the original sale must be turned over to the qualified intermediary, and the replacement property must be equal to or greater in value and equity.
Investors who opt for a 1031 exchange have the option of consolidating their properties. If they manage multiple properties and simply do not have the desire or time to do that anymore, they can exchange their properties for one big property. If they do not want to be responsible for managing the property, they can choose to purchase a property that has an on-site manager. Consolidating can take some of the stress off of investors’ backs and give them more time to participate in other business ventures.
4. Earn More Income
A 1031 exchange also gives investors the opportunity to earn more income. For example, let’s say an investor owns a property that is not generating a lot of revenue. He or she can exchange this property for real estate that has great earning potential.
5. Opportunity to Diversify
Some investors are looking to diversify. They may want to increase their earnings by investing in several types of real estate. A 1031 exchange allows investors to diversify their portfolios.
6. Increased Cash Flow for Reinvestment
If you are able to defer your taxes, you may have more money left over to invest in other properties. You have more purchasing power than if you sold a piece of property and had to pay all the taxes associated with it.
7. Exchange Out-of-State Property
A 1031 exchange is also beneficial for investors who have properties in more than one state. If they don’t want to continue to travel state to state to manage their properties, they have the option of exchanging their out-of-state real estate into property that’s in just one state. This can save them both time and money that it requires to travel to different states on a regular basis.
Of course, there are more details to know and rules to follow, but the basic premise of a 1031 exchange allows an investor to defer taxes, allowing an investor to build wealth. As an investor using a 1031 exchange, you must upgrade, buying a new and larger property, thus growing income and appreciation. There is no limit on the number of exchanges you can make, so a savvy investor can continue to use capital gains to acquire more revenue producing assets. As you look to minimize your involvement but continue to build wealth, you can see why single-tenant net lease (STNL) properties are ideal candidates for 1031 property exchanges.
Although there are many attractive benefits to a 1031 exchange, there are also some drawbacks to be aware of. It is important to take these drawbacks into consideration before opting for this exchange. For example, losses are deferred each year just like taxes. This means if you have a windfall profit year, you have to defer your losses instead of offsetting them for large profits.
Due to the time constraints enforced with a 1031 exchange, it is essential to work with an experienced brokerage firm, like Calkain Companies, LLC, that can help you identify the right property(ies) for your investment. It is a fast process, and Calkain Companies, LLC works with clients to identify opportunities early, so as to ease the anxiety that can occur once the clock starts ticking. For more information or to discuss the potential of your 1031 exchange, contact us at 703.787.4714.