The 1031 Exchange is a Starker Exchange or Like-Kind Exchange. It is the tax deferment strategy utilized by the real estate investor for financial success. Now in the year 2021, it has become a major aspect of real estate. Many investors think that the current time is the right time to exchange the properties in the California market. Then the cash flow will be good.
So are you a real estate investor? Then you may try to sell a property that you have had for many years. During this time 1031 exchange will be useful for you. This tax strategy will be beneficial for you as you can defer the tax payment as long as you require. But this tax strategy can be very difficult to understand. Therefore here you can find all the details about the rules and process of 1031 Exchange.
Table of Contents
- What is a 1031 exchange?
- Why deferring the taxes is good?
- What are the different types of Like-Kind exchanges?
- What is a boot in property replacement?
- What is Tenancy-in-Common in the property exchanges?
- Why is 1031 Exchange important in real estate planning?
What is a 1031 exchange?
The 1031 exchange permit the real estate investors to defer the tax payment when they make a sale of a property. Then they can make use of the proceeds of the sale to buy a new property. So the 1031 exchange is useful for investors who want to buy a better property by selling the old property. They can make sure that the tax does not hit the sale of the old property. The 1031 exchange is from the U.S. Internal Revenue Code, Section 1031.
Further, it is a well-known strategy for the investors who like to sell the property at one market and buy another property elsewhere. But it is useful in many other situations also.
The payment of taxes can get deferred as long as there is no cash received from the property sale. For instance, if a person sells a property and buys another one they will be able to avoid the payment of taxes. So in clear terms, if a person never cashes out they can defer the payment of taxes forever.
Why deferring the taxes is good?
If you are going to sell a property then you have to pay two kinds of taxes. The first tax is known as the capital gains tax. This will apply if you sell an asset for cash more than you paid for it in the first place. For instance, if you use a total of $150,000 to get the investment property and try to sell it for $175,000. Then you gain $25,000.
Also if you have had the property for more than a year then it will be considered as a long-term capital gain. For this, you will get good tax rates. But if you have the property for a year or less then the tax rate will be ordinary. Further, the second type of tax is called depreciation recapture.
This tax is present to offset the depreciation deductions claimed by the property owners every year for the property in their possession. The depreciation is applied 27.5-year period for the residential rental properties. Therefore the $200,000 property will get deducted of $7,273 each year. It will get added up in time and the cumulative deductions will be taken as taxable income.
How to choose the Replacement Property?
There is an important term called Like-kind property. This means that a property has to be looked at for its nature or characteristics and not for its quality or grade. So there is a range of real properties that can be exchanged. For instance, you can get a commercial building with an exchange of vacant land. Or else an industrial property is exchanged by many for residential.
But the real estate property is never exchanged for artwork. This does not come under the like-kind. This property can be kept as an investment and not for personal use or resale for two years of ownership.
To attain the full advantage of the 1031 exchange the replacement property’s value must be equal or great. You have to use the replacement property assets sold within 45 days. Then the exchange must be concluded before 180 days. There are three 1031 exchange rules that can be applied here. At least one must be met. With the three-property rule, you will be able to identify these properties as purchases without any dependence on their market value.
This rule will help you to identify many replacement properties even when their cumulative value is not above 200% of the value in which the property is sold.
This rule will help you to identify as many properties as you prefer. But you have to get properties at the value of 95% of their total or a lot more than that.
What are the different types of Like-Kind exchanges?
There are many possibilities for using the 1031 exchanges that differ in their timing and other matters. Each has some requirements and processes that have to be followed.
- The 1031 exchanges applied before 180 days are referred to as delayed exchanges.
- There are built-t0-suit exchanges that help to use the replacement property in the 1031 exchange. Then the property can be renovated or a new one can be constructed in it. But these exchanges will also come under the 180-day time rule. So all the renovation must be completed before the transaction is over. But the improvements done after it will be considered as personal property. It will not get qualified under the exchange.
- If you obtain the property before selling the property for exchange then it is called the reverse exchange. Then the property is transferred to the exchange accommodation titleholder. Afterwards, an agreement has to be signed. Within 45 days the exchange of property must be identified. In 180 days the transaction must be done.
What is a boot in property replacement?
The properties exchanged in the like-kind property rule must be of the same value. But the term used for the difference in the property and the property which is exchanged for is called a boot.
If the property which is going to be replaced is lesser than the value of the property that is sold then its difference in the cash boot is taxable. If personal property is utilized to finish a transaction then it also can be described as a boot. Further, it also can qualify for the 1031 exchange.
If there is a mortgage present then it is allowable on both sides of the exchange. When the mortgage value on the replacement property is less than the property sold then its difference is considered as a cash boot. This fact has to be checked when calculating the exchange parameters.
Further, the expenses and the fees affect the value of the transactions. It also affects the boot. Also, some of the expenses are allowed to be paid along with the exchange funds. The few of the expenses are-
- Qualified intermediary fees
- Broker’s commission
- Filing fees
- Title insurance premiums
- Related attorney’s fees
- Escrow fees
- Finder fees
Some expenses are not allowed to be paid with the exchange funds and they are the following-
- Property taxes
- Financing taxes
- Maintenance and repair costs
- Insurance premiums
What is Tenancy-in-Common in the property exchanges?
The Tenancy-in-common is one of the variations of the 1031 exchange. It is not a joint venture of property holders but it can be termed as a relationship. This allows a person to have a fractional ownership interest in a large property with 34 people or other entities. Therefore small investors will be able to take part in a transaction.
Further, the Tenancy-in-Common allows the investors the power to own a part of real estate along with the other owners. They will have the same rights as a single owner. Also, they do not require permission from the other owners to buy or sell their part of the property. But they must meet the financial requirements to get the accreditation.
Some of the matters possible through the Tenancy-in-Common are to divide financial holdings, gain share in a larger property, and diversify holdings and more. It allows the people to know the volume of the investment in the project. This action is essential in a 1031 Exchange.
Why is 1031 Exchange important in real estate planning?
One of the major advantages of the 1031 Exchange is that the tax can be deferred how much time you want. If a person dies and his heir gets the property acquired through the 1031 exchange then the value of the property gets stepped up. It will clean slate the tax deferment debts.
So if a person dies without selling the property acquired through the exchange then his heirs will get it as a stepped-up market value. Then he does not have to pay the tax debts at all. The exchange planner can be hired because he will help to take maximum advantage of this situation.
These are some of the important information about the 1031 exchange. You have to know the rules and processes of this exchange to benefit from it. This allows you to defer the taxes which you have to pay for a property as long as you prefer.
Also read: How to Become a Real Estate Agent?