You may have a couple of income-producing assets leased to tenants that must be generating monthly income through rents. However, you must also be paying operating expenses from your income, which may take away a good portion of your money. If you choose to sell one of your properties due to rising maintenance costs, you will have to pay capital gains tax on the transaction. But, you can defer this tax if you do a 1031 exchange on your current property. Plus, on investing the sale proceeds in a net leased property, you can also get rid of landlord responsibilities. A 1031 exchange investment guarantees such massive benefits at no conditions.
There is not one but many reasons why you may want to do a 1031 exchange –
Some of the reasons are explained below:
- You want a property having better return prospects and wish to diversify your investment portfolio.
- You want to get rid of landlord responsibilities and want to invest in properties that are managed by industry professionals.
- You want to consolidate several assets into one or may want to break a single property into several assets.
- Reset the depreciation clock.
The main advantage of doing a 1031 exchange rather than selling out your property and buying another is the tax deferral. A 1031 exchange lets you and other investors defer capital gains taxes, thus liberating more capital for investment in the replacement property.
You must remember that a 1031 exchange may require a relatively high minimum investment and holding time. This makes these exchanges more ideal for individuals with higher net worth. Moreover, because of complexity, 1031 exchange transactions should be handled by professionals.
Role of Qualified Intermediaries in 1031 Exchanges
Under section 1031, the returns received from the sale of the property remain taxable. The sale proceeds must be transferred to a Qualified Intermediary (QI), rather than the seller of the property. The QI transfers them to the seller of the replacement property. A qualified intermediary is a person that agrees to facilitate the exchange by holding the funds used in the transaction until they can be transferred to the seller of the replacement property. The QI can have no formal relationship with the exchanging property parties.
Importance of depreciation in 1031 Exchange for the investor
Depreciation is an essential term for understanding the true benefits of a 1031 exchange. The percentage of the value of an asset written off every year considering the degree of wear and tear is termed as Depreciation. Capital gains taxes are derived after a property is sold based on the asset’s net-adjusted basis, which is important to know the property’s original purchase price, plus capital improvements minus Depreciation.
If you sell the property for a greater price than its depreciated value, you will have to recover the depreciation, which means the depreciation amount will be included in your taxable income received after selling the old property.
Since the depreciation value increases with time, you may want to take the help of a 1031 exchange transaction to avoid the significant increase in taxable income, which depreciation recovery would create in the future. Depreciation recapture is mentioned whenever calculating the value of any 1031 exchange transaction—it is just a matter of degree.
Keep the following things in mind when you hunt for a replacement property –
1031 properties need to be like-kind, which is defined according to its attributes or nature and not its grade or quality. This means that several types of properties are exchangeable. You can exchange a vacant land for a commercial building, or residential property can be exchanged for industrial property or vice versa. However, you cannot exchange real estate for artwork because that does not meet the definition of like-kind. The real estate property must be held for investment and not for resale or personal use. This generally infers a minimum of two years’ of ownership.
As per 1031 exchange rules, the replacement property should be of equal or greater value. You have to identify a replacement property for the assets sold within 45 days and then finalize the exchange within 180 days. The three rules that need to be followed to define identification are discussed below. The investor has to meet one of the following rules:
- The three-property rule lets you identify up to three properties as potential purchases regardless of their market value.
- The 200% rule allows you to identify any number of replacement properties as long as the total value does not exceed 200% of the value of the property sold.
- The 95% rule allows you to identify as many properties as he wants as long as he acquires the property valued at 95% of their total value or more.
A 1031 exchange can be completed in a number of ways –
A unique aspect of the 1031 Exchange is that it can easily be customized as per your immediate need. Each kind of 1031 Exchange has a different set of prerequisites and procedures that must be followed:
- Simultaneous Exchange – It’s the oldest form of 1031 exchange. A Simultaneous Exchange requires an investor to sell their relinquished property and buy the replacement property at the same time. An investor doing a simultaneous exchange must complete the entire exchange in one day. Due to such a stiff deadline, barely any investor opts for a simultaneous exchange nowadays.
- Delayed/Forward Exchange – A Delayed or Forward or Starker Exchange is a typical 1031 exchange under which you must first sell your old property and then invest in the new asset. Once you sell your old property, you get 45 days to identify the potential replacement property and 180 days to complete the exchange.
- Reverse Exchange – A reverse exchange is just the opposite of a delayed exchange. In a reverse exchange, you need to purchase the replacement property and then close on the sale of the relinquished property. Under no circumstances, the investor can hold the title of both relinquished and replacement properties at the same time.
- Built-to-suit or Improved Exchange – A built-to-suit or an improved exchange allows an investor to withdraw a portion of their proceeds and invest it for carrying out some repairing or improvement work in the replacement property. The investor must complete all kinds of improvement works before acquiring the replacement property, that is, within 180 days.
We believe that all the information provided above will help you in planning your 1031 exchange. However, you may want to talk to a 1031 expert or reach out to a 1031 exchange company to discuss your financial situation. Swapping properties is subject to availability. That’s why you must plan a 1031 exchange in advance.