If you are a real estate investor and are looking to sell some or all your appreciated real estate assets, one consideration is the tax liability at the disposition of your property. Depending on certain factors, the tax bill generated from the sale of one or all your properties can be a hard pill to swallow. It may even discourage some investors from selling their property to avoid forking over proceeds from their hard-earned assets to Uncle Sam. However, there is a tool that can serve as a solution to this problem, known as the 1031 exchange.
This is a procedure that allows the owner of investment property to sell it and buy like-kind property while deferring capital gains tax. On this page, you’ll find a summary of the key points of the 1031 exchange—rules, concepts, and definitions you should know if you’re thinking of getting started with a section 1031 transaction.
BRIEF HISTORY OF 1031 LIKE-KIND EXCHANGE
The 1031 Like-Kind Exchange was first introduced by Congress in 1921, realizing the importance of encouraging reinvestment in business assets. The 1031 Like-Kind Exchanges gets its name from section 1031 of the IRS tax code. The code provides that you will not recognize a taxable gain on real estate exchange, provided you meet the IRS requirements.
WHAT IS A 1031 LIKE-KIND EXCHANGE?
A 1031 Exchange allows real estate investors to completely defer all federal and state taxes on relinquished property when the investor reinvests their sale proceeds into a “like-kind” property. Often, investors can be confused about what a “like-kind” property is. “Like-kind” means you are selling one piece of investment real estate and buying another piece of investment real estate. You also do not have to remain in the same real estate sector, allowing you to exchange virtually any real estate for any other property, except for personal property, as this specific asset class does not qualify for the exchange.
1031 Like-Kind Exchanges provide tax deferral, not forgiveness. If you eventually sell the replacement property without exchanging the proceeds into yet another ‘like-kind” property, you will realize the gain, and a tax bill is due.
WHAT IS A QUALIFIED INTERMEDIARY?
A Qualified Intermediary, also commonly known as the accommodator or QI, is an entity that facilitates Section 1031 tax-deferred exchanges. The QI enters into a written agreement with the real estate seller to make sure the process of the 1031 Like-Kind Exchange flows smoothly and efficiently.
QIs play a pivotal role in a 1031 exchange. Some of their responsibilities include preparing the exchange agreement, holding the net sale proceeds from the relinquished property in an escrow account, helping to identify replacement properties, and transferring funds to purchase the replacement properties. They may also provide in-house legal and tax teams to provide additional support.
WHAT IS A 1031 LIKE-KIND EXCHANGE TIMELINE?
The timeline of a 1031 Like-Kind Exchange begins with the sale of the relinquished property. The qualified intermediary holds the proceeds from the sold property. Within 45 days of the sale date, you must identify the potential replacement properties to exchange the sale proceeds. Finally, you must complete the acquisition of any replacement properties by 180 days from the sale date.
WHAT ARE THE BENEFITS OF A 1031 LIKE-KIND EXCHANGE?
Portfolio Diversification/Consolidation: As a real estate investor, you can exchange one higher valued property for several other properties to own a diverse group of real estate investments. You are not limited to a specific geographical area when doing a 1031 Exchange allowing you to purchase property anywhere within the United States. On the other hand, if you find a great investment opportunity in a larger property, you can exchange multiple properties with lower values into one higher valued property.
Access to Higher Quality Real Estate: By not paying taxes on the relinquished property, the money you would have paid to the government you can use to trade up for your benefit. It allows you to potentially purchase more expensive or higher-quality real estate that better matches your investing goals and needs.
Potential Tax Forgiveness to Your Heirs: If you own appreciated real estate when you die, your heirs will receive a step-up up in cost basis equal to the fair market value at the time of your death, eliminating a large tax bill. However, you may want to sell appreciated properties during your life for any number of reasons. For example, you might believe the price is attractive to sell, or you may want to eliminate the headaches of being a landlord. In these cases, a 1031 Like-Kind Exchange eliminates several taxes, including federal and state capital gain and depreciation recapture taxes. For this reason, 1031 Exchanges can be a great strategy to transfer more of your wealth to your heirs instead of paying taxes to the government.
WHAT ARE THE DRAWBACKS OF A 1031 LIKE-KIND EXCHANGE?
Tight Timeline: As discussed, you must follow a strict timeline to complete a 1031 Like-Kind Exchange successfully. Failure to meet any step within its specified time frame can result in the termination of the exchange. A 1031 Like-kind Exchange may not be the best option if you are not prepared to move quickly. Consider lining up a commercial real estate agent, a qualified intermediary, and an attorney ahead of time to help you meet the timeline. A wealth manager specializing in the needs of successful real estate investors can help you assemble a knowledgeable and experienced team to help you complete the process successfully.
Liquidity: The assets from the sale of the relinquished property will remain invested in real estate. You will not be able to use proceeds for any other use, whether personal or business-related. To access funds for use other than investment real estate purchases, you will have to realize all or part of the gain and pay all applicable taxes.
Taxable Boot: The term “boot” means any money left over from the sale of your property after you close. Although this is a case-by-case basis, any money leftover from the deal you do not exchange into “like-kind” property can incur a taxable gain.
It’s easy to see why a 1031 Like-Kind Exchange is a valuable tool for successful real estate investors. However, it must be executed correctly and on time. Therefore, it is essential to reach out to a knowledgeable professional to help guide you through the exchange process.
DISCLOSURE & ACKNOWLEDGEMENT
The information included in this material is for informational purposes only and should not be relied upon for any financial or legal purposes. Arlington Capital Management Inc, dba Arlington Wealth Management (AWM) is an investment adviser registered with the U.S. Securities and Exchange Commission. Our registration with the SEC or with any state securities authority does not imply a certain level of skill or training, nor are we selling you any product. Rather, we are seeking to provide you with advisory services. Please consult with your own tax and legal advisers before investing. AWM cannot and does not guarantee the performance of any investment. Past performance is no guarantee of future results.