The sales or placement of business assets, including real estate, usually invites tax liabilities for sellers. Ideally, any sale of a sizable or expensive asset like a business property or hotel could bare an investor to heavy tax liabilities, decreasing their ability to engage in any future investment. Section 1031 of the Internal Revenue Code provides a solution to this commonly faced issue. 1031 Exchange promotes a tax-deferred option.
Understanding Section 1031 of IRC
1031 Exchange comprises a well-structured exchange of investment real estate. In a 1031 exchange sale, the investor does not ordinarily “swap” property with another investor. Rather, the investor trades one asset and acquires replacement like-kind property within a specified time period.
As per the 1031 exchange rules –
“No loss or gain is recognized on exchanging real estate occupied for business or investment purposes. If such assets are exchanged solely for like-kind properties, an investor can defer entire capital gains tax.”
To benefit from this favorable tax treatment, investors looking to sell investment property should carefully examine whether re-investment in like-kind property is a suitable option.
Benefits of a 1031 Exchange
1031 exchange got popular after IRS issued guidelines in Section 1031 of the U.S. Internal Revenue Code, which allowed parties to defer paying capital gains taxes upon the sales of an investment property and reinvest the sale proceeds within specified time limits in a property or properties of like-kind which could be equal or greater in value. Sales involving 1031 Exchange is one of the most powerful wealth-building tools accessible to taxpayers. 1031 Exchange is considered a highly successful strategy by financial advisors. Investors get to defer taxes on the sale of the property till the time IRS rules are meticulously followed. 1031 Exchange sale is not only a brilliant strategy for saving taxes and promoting investment, but it also acts as a brilliant estate planning tool. In theory, an investor can defer capital gains on investment property indefinitely until death, possibly avoiding them altogether.
How does a 1031 exchange sales work?
Let’s look at the following example to understand the 1031 exchange process –
Say after selling a property, you have $500,000 in gain and $500,000 net proceeds. Usually, a $500,000 capital gain will lead to a tax liability of approximately $160,000, including the federal capital gain tax, state capital gain, income tax on net investment, and tax depreciation recapture on the sale of the property. There will be net equity of $340,000 that you can reinvest in a different property.
Let us consider a 25% down payment and availing of new financing for the acquisition with a 75% loan-to-value ratio; in this case; you will only be able to purchase a $1,040,000 replacement property.
However, if you choose to exchange, you will be able to reinvest the entire gross equity of $400,000 to purchase $1,600,000 replacement property, considering the same down payment and loan-to-value ratios.
As the preceding example explains, tax-deferred exchanges enable investors to defer capital gain taxes, promote meaningful portfolio growth, and increase return on investment.
The benefits of a 1031 exchange sale can be notable for taxpayers who hold investment property. Taxpayers could defer all capital gain taxes, depreciation recapture, net investment income tax (NIIT), and state taxes. Once a valid 1031 exchange requirements are met, capital gain recognition can be delayed until the taxpayer wishes to recognize it.
For instance, a married couple filing jointly trades an investment property in California for $1,000,000 (net of closing costs) with no debt. The couple acquired the property for $400,000. Seventy-five percent, or $300,000 of the initial purchase price, was designated to the building and has been fully depreciated. The capital gain is around $900,000 (today’s sales price of $1,000,000 minus the net adjusted basis of $100,000). This is the primary source of the couple’s investment income. The couple’s modified adjusted gross income is $1,400,000 (which includes income from other sources and capital gain from this sale) to calculate the net investment income tax. The couple will be taxed at 25% for their prior depreciation deductions taken, 20% federal capital gains tax rate, the 3.8% net investment income tax, and they will be in the 13.3% California state tax bracket.
The benefits of IRC Section 1031 exchanges are enormous! Conversely, the impact of not doing an exchange can be simply mortifying. Investors are often qualified to delay hundreds of thousands of dollars in capital gain taxes, both at federal and state levels.
Why should you invest your 1031 proceeds into DSTs?
Though there are various reasons why you should take DST 1031 investments seriously, a few of them are:
- Relief from property management – One of the biggest reasons investors invest in DSTs is that it provides relief from property management. DST properties come with pre-arranged property or asset managers. Therefore, DST investors don’t need to bear the burden of property management.
- Gain non-recourse debt – Being an accredited investor, you must be interested in institutional-grade, pre-arranged, and non-recourse financing with easy approvals. As a DST investor, you can invest in properties ranging from all-cash debt-free acquisitions to properties with up to 85% leverage.
- Low investment – Due to DSTs’ large structure, an investor doesn’t need huge capital to start with a DST investment. A DST investment may start from as low as $100K. It’s a blessing for investors who want to own institutional-grade properties but don’t have the capital required to own such properties.
- Diversification – DST investors can split their proceeds and spend them on different properties or assets. This helps investors diversify their investment portfolio by investing in properties of different grades.
- There is no need to sweat for locating properties – As a DST investor, you don’t need to get on the street to locate properties. The real estate firm is responsible for locating properties on behalf of the investors.
DST 1031 exchange properties often have many more benefits. Like, you receive high income, numerous tax advantages, an opportunity to 1031 exchange in and out your proceeds, etc., if you invest in DSTs.