Investors often have to deal with the rising maintenance cost on their properties, along with the passage of time. As a property grows old, it requires maintenance on a regular basis, which indirectly requires more money and time. In order to deal with the ever-rising maintenance cost, investors often look to sell out their properties and reinvest the proceeds in some other kind of property or assets. In the process, they also need to pay the taxes imposed by the State as well as the Federal government on the capital gains. However, on account of doing a 1031 exchange, an investor can defer up to 100% capital gains tax.
What is a 1031 exchange?
Section 1031 of IRC, commonly known as 1031 exchange, lets real estate investors defer capital gains tax and exchange investment properties. Using a 1031 exchange, an investor can exchange any investment property for another and defer capital gains tax. Properties involved in 1031 exchanges must be held for use in trade, business, or for investment purposes. Unfortunately, personal properties don’t qualify for 1031 exchanges.
The term ‘like-kind’ means that properties exchanged using a 1031 exchange must be similar in nature. The majority of investors often judge this term incorrectly. Properties exchanged using a 1031 exchange just need to be similar in nature and needn’t serve the same purpose. Section 1031, in no way, requires the properties to serve the same purpose or used in the same way. That’s the reason why any investment property can be exchanged for another using a 1031 exchange.
How to choose your 1031 exchange replacement property?
Every investment is different, and every investor has their own specific needs. The condition that suits one investor may not be good for the other. Therefore being an investor, you must know your requirements and invest accordingly. For example, if you want to get rid of the burden of property management, you can invest in a DST and complete your 1031 exchange.
A Delaware Statutory Trust or a DST is a private governing trust responsible for buying, managing, administering, and selling real estate properties. DSTs have large institutional-grade properties in their portfolios that often come with pre-arranged property or asset managers. Any accredited investor can buy ownership in DST properties with the help of a real estate broker or agent.
A single DST may have a hundred or even more investors as DSTs generally have a large structure. This is an advantage for small investors as by investing in DSTs, they can acquire large institutional-grade properties, which otherwise they may not be able to afford individually.
The IRS requires you to follow a set of rules to qualify for a 1031 exchange.
Though it isn’t too difficult to execute a 1031 Exchange, particularly if you’ve done it earlier as well, however, you should stick to the following steps in order to carry out the transaction smoothly –
- Hire a Qualified Intermediary and enter into a 1031 Exchange agreement along with him. Not to mention, the participation of a Qualified Intermediary in 1031 Exchanges is mandatory.
- Once you sign the agreement, the Qualified Intermediary will start looking for a buyer for your relinquished property.
- Identify a new asset within 45 days after you receive the price of your old property. This is your ‘identification period.’ You must send a written identification of the replacement property, including the street address, to 1031 Corp on or before the 45th day.
- After identifying the potential replacement property, all you need to do is acquire the same within 135 days. You’ll get 180 days in total for completing your exchange, which starts the day your relinquished property is sold. However, your 1031 Exchange will no longer be valid in case you fail to meet any of the deadlines.
- At last, you’ll have to submit form 8824 to the IRS at the time of filing taxes along with other required documents.
It’s evident that you’ll be able to complete your 1031 Exchange smoothly if you follow the above-mentioned steps. However, another thing that can certainly affect your 1031 Exchange is how you choose your 1031 investment property. As we had mentioned earlier, 1031 Exchanges don’t only provide the benefit of tax deferment but a lot more advantages as well, like diversification, leverage, relief from property management, etc. However, once you’ve completed your 1031 Exchange and deferred capital gains taxes, you can only expect your replacement property to generate more revenue than what your relinquished property was generating. After all, why would anyone exchange their property for another if the replacement property doesn’t generate more revenue than the relinquished one?
Things you should consider while choosing your 1031 investment property?
- Make sure that the Fair Market Value (FMV) of the replacement property is equal to or greater than that of your relinquished property.
- In case the fair market value of the replacement property is less than that of the relinquished property, then that will result in ‘Boot,’ and you will have to pay the taxes on the profit. A Boot can be defined as the ‘cash or profit received by the investor’ in the exchange. Boot eliminates the opportunity of tax deferment.
- Another thing that you should take into account is the running debt on the replacement property. You must acquire a replacement property that has the same debt as your relinquished property.
- The location of your replacement property also plays a vital role. Using a 1031 Exchange, you can acquire a replacement property anywhere in the entire USA. You must look for properties that are built-in developed localities as it will increase the cash flow.
Locate ideal DST properties in no time –
Certainly, you don’t need to get on the streets for locating 1031 exchange DST properties. You can consult a real estate broker, and they can provide you with different DST investment options. Once you’ve picked a DST in which you want to invest, you can explore the properties included in its portfolio.
There is another way using which you can locate DST properties, and it’s a lot easier. You can consult a 1031 exchange advisor or expert, and they can suggest you different DST investment options. We, at 1031xchange.com, can connect you with a team of highly qualified 1031 exchange advisors, and you can speak to any one of them. All you need to do is let us know your requirements and a 1031 exchange advisor will be at your service in the very next moment.