If you possess investment property and contemplate selling it to acquire another, familiarizing yourself with the 1031 tax-deferred exchange is highly recommended. This process enables investment property owners to sell their current assets and purchase a like-kind property all while postponing capital gains tax. Here is a condensed overview of essential aspects of the 1031 tax-deferred exchange—rules, principles, and terminologies—that you should acquaint yourself with if you are considering embarking on a section 1031 transaction.
1031 Exchange—What is It and Why it Matters?
A 1031 exchange involves trading one real estate investment property for another, enabling the deferral of capital gains taxes. This concept originates from Section 1031 of the Internal Revenue Code (IRC) and is discussed among real estate agents, title companies, and investors.
Investors employ this provision when they sell a property and then reinvest the proceeds into one or more other properties. However, it’s important to note that this option doesn’t apply to individuals buying or selling personal homes for their use. Such transactions that meet the criteria of Section 1031 are referred to as 1031 exchanges, like-kind exchanges, or Starker exchanges.
Generally, a 1031 tax deferred exchange (also referred to as a like-kind exchange or a Starker exchange) involves exchanging one investment property for another. While most exchanges are subject to taxation as sales, if your exchange satisfies the conditions of 1031, you may either owe no tax or have limited tax liability at the exchange’s time. Essentially, you can alter the structure of your investment without, according to the IRS, cashing out or acknowledging a capital gain. This enables your investment to persist in growing tax-deferred.
Section 1031 postpones taxation on exchanges of similar real estate completed promptly. Several crucial steps are involved in a well-organized 1031 exchange:
- The acquired real estate using the proceeds must be similar.
- Taxes must be settled on any “boot” during the year of the 1031 exchange. Boot refers to added value to the exchange that doesn’t involve real estate.
- After selling the business or investment real estate, one must identify similar real estate within 45 days and acquire it within 180 days.
Advantages of 1031 Exchange
Facilitating the sale and purchase of properties benefits the strength of the real estate market, which in turn benefits the entire nation. Real estate investors gain the advantage of faster investment opportunities, tenants have a more comprehensive selection of properties, and a robust real estate market contributes to national strength, benefiting the government.
Let’s examine the primary advantages of 1031 tax deferred exchange to help you determine if this strategy aligns with your goals.
● Frequently, real estate investors seek to diversify into different real estate markets across the United States. The 1031 exchange swiftly divests their current real estate holdings, enabling them to access new markets for potentially higher returns. State boundaries do not confine 1031 exchanges. It can be executed nationwide.
● Much like the rationale for consolidation, even the ownership of a single large rental property with multiple units can demand significant management attention. Over time, many multifamily property owners become weary of the challenges associated with tenants, maintenance, pests, and waste disposal, often called the “Four Ts.” To address these issues, many investors opt for a 1031 exchange to acquire replacement properties with long-term net leases, where tenants assume most or all maintenance responsibilities. This arrangement offers predictable rental income, consistent cash flow, and potential for equity appreciation.
● By deferring capital gains taxes, you can accelerate wealth expansion as the initial investment amount grows more extensive. With a 1031 exchange, investors can postpone these taxes and reinvest the complete return from their investment into subsequent deals. Each investment can repeat this process, contributing to your wealth expansion over time.
Conclusion
The primary advantage of conducting a 1031 tax deferred exchange instead of simply selling and buying another property lies in the tax deferral. You might be aiming for a property with more significant return potential or seeking to diversify your assets. As an owner of investment real estate, you might prefer a managed property over self-management. However, it’s crucial to note that a 1031 exchange may entail a relatively high minimum investment and holding period, making it more suitable for individuals with substantial net worth. Additionally, due to their intricacy, 1031 exchange transactions should be managed by professionals.
