Take 1031 Exchanges. This well-known financial maneuver is lauded as intelligent means to utilize the tax code to an investor’s advantage.
But what does it mean?
Let’s look into the 1031 Exchange so we can understand its nuances, establish how it can work for you, and why it’s important to know about.
What Does 1031 Exchange Mean?
The name “1031 Exchange” sounds like an obscure real estate legalese piece.
Its name refers to a specific section in the Internal Revenue Code–Section 1031. The legal repercussions of Section 1031 have far-reaching consequences. This code section provides real estate investors with significant advantages for optimizing their investments.
1031 Exchanges translate into considerable benefits that make real estate investing easier for the investor. The stipulations outlined in this particular section of the IRC allow investors to exchange one real estate asset for another while avoiding capital gains taxes.
How Does a 1031 Exchange Work?
Without a 1031 Exchange, investors seeking to swap one investment property for another would first need to liquidate their assets from their holding, then acquire their desired property with the liquidated capital.
This process of buying and selling takes a long time. Closing on a property can take many months—real estate is well known for its high illiquidity.
Worse yet, the buying and selling of the properties levy taxes like capital gains on the investors’ assets.
Under normal circumstances, swapping one property for another becomes costly in terms of time and money for the property owner.
1031 Exchanges alleviate these costs and simplify these one-to-one swaps.
With a 1031 Exchange, investors avoid the burdensome hold-ups, like capital gains taxes. When they qualify, a 1031 Exchange simply swaps the exchange properties delaying the levy of taxes or bypassing them altogether.
How does a swap qualify for a 1031 Exchange?
Rules For 1031 Exchanges
The property swaps allowed by 1031 Exchange must follow certain rules. Here are some of the key rules that exchanges must follow if investors want to take advantage of their benefits.
Must Be A Business or Investment Property
To qualify for a 1031 Exchange, the property must be used either for business or for investment purposes, i.e; the property must be shown to be squarely in an income-earning real estate asset class.
Only these types of real estate assets can be exchanged.
What About Your Home?
Home owners cannot do an exchange on their primary residence. However, primary residences can qualify for a 1031 exchange if the owner can transition the property into an income-earning property.
To do so, the property owner would need to rent out the space and show that they had not lived in the property for at least a year.
As long as a real estate asset can be shown to earn an income, it may qualify for a 1031 Exchange. Other than that, an office building.
Must Be a “Like-Kind Exchange”
Section 1031 dictates that to bypass taxes on a swap must be a Like-Kind Exchange.
The qualifications for a like-kind exchange are as vague as they sound. Two different real estate types, like a commercial property for a vacant lot, can still qualify as like-kind. As long as they are the same asset class, even different types of property are considered like-kind.
Limitations on Like-Kind Exchanges
For example, you cannot use 1031 exchanges to acquire second homes or vacation homes as they are not considered like-kind exchanges in this context—as personal use properties, they are considered to be in different asset classes.
To qualify a vacation home for a 1031 exchange, the investor must first rent out the property and demonstrate that it earns them an income.
Delayed Exchanges Require A Qualified Intermediary
For an immediate swap, both parties involved in the exchange need to completely agree.
Because it is unlikely that a prospective swapper will find someone willing to make such an exchange right away, delayed exchanges allow an investor to “sell” their property so they can “buy” the property they want.
To ensure that the funds are used for the stated purpose of the swap, delayed exchanges require a qualified intermediary to hold the cash in escrow for the swap until the exchange is finalized.
Sales Proceeds For The Swap Must Be Used in 180 Days
There is a strict time frame in which the swap must be made to qualify.
The capital liquidated for the first property must be used within 180 days to qualify. This ensures that the exchange is done in good faith, as the time limit ensures that the tax-free capital is recirculated back into the market.
In addition to the 180-time frame, investors must choose the property they want to swap for within 45 days. This stipulation is another way to ensure that investors act in good faith and use the capital saved from the tax break for their stated purpose: acquiring a qualifying, like-kind property.
No Limits on 1031 Exchange
Investors can do a 1031 Exchange indefinitely.
For example, an investor may continue to defer the capital gains tax on their property swap on multiple properties as long as the exchanges are similar. Capital gains can be deferred indefinitely as long as they are carried out through continual like-kind exchanges.
The fact that exchanges are unlimited means that investors have the opportunity to pursue better investments in the future without the burden of taxes on their capital.
You Can Do Exchanges In Reverse
Investors can acquire their intended replacement property and then retroactively initiate a 1031 Exchange.
To do a reverse exchange, the investor simply needs to hand the new property over to an exchange accommodation titleholder. This third party holds the legal title until the swapped asset is officially sold.
The same time frame limitations apply to reverse exchanges. The investor needs to find the potential replacement properties within 45 days, then finalize the sale at least 180 days before acquiring the replacement property.
Depreciable Property Stipulations
When investors make improvements on a property that accounts for normal wear and tear, they can write off the expenses as a tax break with depreciation.
However, investors will end up paying for those tax breaks if they sell an improved property for a profit. In this scenario, the property seller will have to pay for depreciation recapture, which taxes the depreciated expenses written off as ordinary income.
Avoid Depreciation Recapture
If a property swap qualifies for a 1031 Exchange, depreciation recapture can be avoided by swapping those same depreciation write-offs to the new property.
Ordinary income is generally taxed higher than the more beneficial long-term capital gains rates. Investors interested in 1031 Exchanges are advised to assess how depreciation could affect their swap to ensure they are not stuck paying depreciation recapture.
Have questions about depreciation recapture? Feel free to contact Christina’s professionals for quality real estate advice.
Recent Changes to the Rules
The Tax Cuts and Jobs Act made some alterations to 1031 when it was passed in December of 2017. Here are a few ways legislation affected how 1031 Exchanges are done.
Only Real Property Qualifies
Before the rules were changed in 2017, a wider range of property types could qualify for the deferred tax. Personal property like heavy machinery and business licenses could be swapped. However, changes to the tax code have made 1031 Exchanges exclusive to real estate.
Why A 1031 Exchange is Important
Real estate investing can get very expensive. The property prices are rising, meaning that down payments alone are rising with them. The burdens taxes can have on this already costly investment don’t give much incentive for investors to step into the real estate market.
1031 Exchanges are so important because they defer burdensome taxes levied in real estate sales so that more investors are incentivized to buy property.
Understanding 1031 Exchanges can help investors like you make better-investing decisions.
Pay Less on Capital Gains When You Finally Sell
When investors finally liquidate their property for good, they pay less in taxes.
Capital gains are generally taxed at the short-term capital gains rate: 10% to 37% of the gains made. However, due to postponement from the exchange, sellers may be able to qualify for the long-term rate: 10% to 20%.
The longer rate takes effect if the sale is made at least one year after the initial purchase date. The tax deferments of a 1031 Exchange allow investors to bypass the short-term rate and pay less in taxes when they finally sell.
Investors Have More Money To Invest
The money investors would pay on capital gains taxes can be utilized to purchase better investments.
As long as the swap is of like kind, investors can increase the capital they use for the swap by deferring the taxes owed on the property. Investors can acquire increasingly valuable investment properties when utilized correctly by deferring their taxes.
The access to larger amounts of capital frees investors to get even better gains with every investment.
1031 Exchanges allow investors better opportunities to build a stronger real estate portfolio.
It works. At Christina, we’ve built a high-performance portfolio in one of the market’s most hyper-prime real estate markets, thanks in no small part to the financial doors opened by 1031 exchanges.
Gains and Losses Are Deferred
One thousand thirty-one exchanges give investors the advantage of deferring the taxes on their gains on their assets. However, just as payments are deferred through the exchange, so are losses.
Under normal circumstances, investors could write off losses on their investment, crucially allowing investors to find some compensation for the lost wealth.
1031 Exchanges do not carry that same benefit if investors are in the red with their assets. Before engaging in a 1031 exchange, consider how such a swap accounts for the gains or losses you’ve made with the asset.
If you’re in the green, you benefit. If you’re in the red, you don’t.
Invest With The Best
Navigating the Internal Revenue Code is difficult to do as an individual investor.
Professional firms like Christina are fluent in real estate legalese. That’s why we’ve thrived for decades in one of the country’s most exclusive real estate markets: Los Angeles’ Westside region.
Leave your investments in good hands. Get started with us today.