At the most basic level, a 1031 Exchange is the swap of one business or investment asset for another.
Before making any decisions, it’s important to do the math first and consult with experts. Although a 1031 Exchange is not restricted to only real estate (fine art is one of those investments), it is definitely where most of the discussion takes place. The majority of like kind exchanges are taxable as sales, but if you meet the requirements, you can take advantage of limited or no taxes due at the time of sale by utilizing the IRS 1031 Exchange tax code. This means you can trade or exchange your investment and defer your capital gains instead of cashing out, allowing your investment to grow tax deferred. And, there is no limit to how many times you can implement this.
Knowing exactly what asset you’re going to exchange into is nearly impossible, but it doesn’t mean you can’t have a game plan.
For most of us, the only time you’d ever encounter the Capital Gains Tax is during the sale of a home. This is where the government takes a piece of the profit from the sale of an investment. However, there are ways to grow an investment tax deferred. This is where a 1031 Exchange Program comes in. If you have owned your home or property for more than a year, this is now your investment asset. Congrats! A 1031 Exchange can open up unique investment opportunities. Let’s explore this a little further.
When it comes to a 1031 Exchange, special rules do apply.
As with everything else in life, if it sounds too good to be true, it probably is. That is why it’s crucial to get assistance from a professional before making any decisions. As a model for good practice, here are 5 things you need to know now.
1. There is a timeframe
At the close of escrow of your down-leg, you have 45 days to identify three potential properties or 200% of the fair market value of the property sold. You have a total of 180 days to purchase your exchange property after selling the prior investment property.
2. Like-kind property is vague.
The use of the term “like-kind” is very important to note. According to the IRS, it refers to the nature of the investment, rather than the form. For example, you can exchange an apartment building for a net leased investment or even a walnut farm… and vice versa, be sure to talk to your consultant about how this can trigger depreciation recapture.
3. Don’t touch the proceeds from your sale.
At closing, it’s important to not have the proceeds from the sale touch your personal or business account. Instead, make sure you use an accommodator to secure the funds in between selling your down-leg and purchasing your up-leg. Even if the funds are placed into your account for less than an hour, this would likely trigger a tax consequence.
4. Replace your proceeds and debt.
When purchasing an exchange property you must replace the cash proceeds plus the debt from the property you’re selling on your next investment. For example, lets suppose you sell a property $1M, receive $500,000 in cash proceeds, and had a loan of $450,000. You have to use the entire $500,000 of cash proceeds plus replace the $450,000 loan. If you take out some of the cash or get a smaller loan, this will be considered “boot” which is a taxable event.
5. Investment properties only.
You cannot use the funds from your proceeds to purchase personal property. This means you cannot sell your apartment building to purchase a new home or use the money to fund your dream vacation. When you sell an investment property, you must purchase another investment property.
If executed correctly, a 1031 Exchange, should result in no current taxes upon sale and it will continue to grow tax deferred. It’s important to do your research and we encourage you to speak to a 1031 exchange accommodator, attorney, and CPA before doing an exchange. The American Bar Association reports that there is a proposal in Congress to repeal this section of the tax code. In the meantime, you should take advantage of it to reposition your investment portfolio.
Be sure to contact an agent at Matthews Real Estate Investment Services to implement a plan for ensuring a successful 1031 exchange.