If you’re a real estate investor, you’re probably familiar with the 1031 Exchange. This is a reference to Section 1031 of the US Internal Revenue Service’s tax code. The 1031 Exchange creates provisions for property owners to defer capital gain taxes while facilitating significant portfolio growth and increase in investment.
To qualify, most exchanges have to be ‘like-kind’ – which allows investors to easily exchange a ranch for raw land or an apartment building for a strip mall. It may be possible to exchange like-kind businesses.
It is worth noting that the IRS has revised the 1031 to eliminate (or mitigate) several loopholes (to prevent the easy swapping of vacation houses). Because of the complications involved in a 1031 Exchange, it’s highly recommended to work with a professional.
A 1031 Exchange Can be a Hit or a Miss
As an investment tool, the 1031 Exchange is a powerful mechanism when used in the right hands. You could potentially defer capital gains taxes indefinitely by continually structuring and using different 1031 strategies. If done right, the taxes can be deferred throughout the investor’s lifetime, and their heirs will receive a step-up in cost equal to the market value at the time of the investor’s passing. This effectively eliminates capital gain and depreciation recapture taxes altogether.
To qualify for a 1031 Exchange, investors must acquire replacement properties. For example, you could exchange a high maintenance property for a low maintenance property without paying too many taxes. Or perhaps you want to invest in a different location. This is possible with a 1031 Exchange.
Yet, many investors are not able to reinvest and acquire replacement property as required by the IRS. For starters, there is a very low statistical possibility of finding someone willing to buy your property in exchange for their property. This is why the majority of 1031 Exchanges are Delayed Exchanges, involving an IRS-approved third party.
Most Common Types of 1031 Exchanges
In this section, we’ll give you a rundown on 4 types of real estate exchanges
In a delayed exchange, you sell your property and give the cash to a middle man to buy the replacement property on your behalf. Using this strategy, investors have a maximum time period of 45 days to identify a replacement property and 180 days to complete the sale of their property.
Simultaneous exchange only occurs when the relinquished property and replacement property are closed on the same day. This means that any delays, possibly resulting from wiring money to an escrow account, could disqualify the investor from the exchange and trigger full taxes.
A reverse exchange is when you acquire the replacement property first, and then trade away your currently owned property. A reverse exchange is an effective way of helping buyers purchase a replacement property before being forced to sell the relinquished property. Reverse exchanges are difficult because they require all cash. This is complicated because most banks won’t offer loans on reverse exchanges.
The construction exchange, or improvement exchange, allows investors to improve their replacement property by using the proceeds from selling their relinquished property. The investor must meet cerate requirements to qualify for the improvement exchange.
If you want to learn more about 1031 Exchanges and if they align with your investment goals, get in touch with our team at JD Title & Escrow Services on this link or call at 239-984-5028 for free consultation.