1031 Exchanges: How They Can Help You
A 1031 exchange can be a smart way to exchange investment properties while deferring taxes. It can also be an excellent estate planning tool. Keep reading to learn more about Section 1031, and how it can help you.
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What is section 1031?
A 1031 exchange, also known as a like-kind exchange, allows investors to swap one real estate investment property for another, as long as the second property is bought with profits earned from the sale of the first. The entire net sales price of the first property must be reinvested, not just the profits.
By performing a 1031 exchange, you’ll have limited or no capital gains taxes due at the time of exchange. You only have to pay taxes when you eventually sell for cash. Basically, you’re able to exchange your investment without having to claim a capital gain.
There is no limit to the number of times you can do a 1031. The money earned from each investment can be used to purchase a new, ‘like-property’ many times over. A 1031 exchange can only be used for business and investment properties (though there are exceptions for personal residences).
What does like-kind mean?
Like-kind is defined by its characteristics, not its grade. There are a wide variety of exchangeable properties that fall under this category. For example, a commercial building could be exchanged for residential. Since 2018, 1031 exchanges only apply to real estate. Personal or resale use is prohibited.
When a 1031 exchange is a smart move
A 1031 exchange is a tax-deferment strategy that can help increase your cash flow by allowing you to legally put off paying your taxes. It is considered a transfer of property, since no economic gain has been made by selling one property to purchase another.
1031 exchange requirements
You’ll have 45 days to identify an exchange property and 180 days to complete the exchange.
There are rules which limit the number of properties a taxpayer can identify. If you plan to buy multiple properties, they must fall under one of the following classifications:
- 3-property rule: Identify up to three potential properties of any value. You must intend to purchase at least one of them.
- 200% rule: Identify any amount of replacement properties as long as their combined value doesn’t amount to more than 200% of the new property’s value.
- 95% rule: Identify a minimum of three properties with a combined value of over 200% of the new property’s value, as long as you acquire 95% of the value of the market value of these properties. This rule is less commonly used.
Does my property qualify?
Both properties in the exchange must be held for either:
- Business or trade use
- Investments that are either expected to go up in value (i.e. land you plan to sell at a later date for profit) or that generate income (a rental property you lease out).
Personal use property, like your primary residence, will not qualify. Vacation homes can qualify only under very specific criteria. Other exclusions from Section 1031 include:
- Certificates of trust
- Bonds, stocks, and notes
- Partnership interests
1031 and estate planning
A 1031 exchange can also act as an excellent estate planning tool. Normally, selling appreciated real estate can result in capital gains taxes as high as 24% federally, and up to 12% in state taxes. This means less money that you’d be able to pass on and/or reinvest. Rather than having to sell property and pay taxes, a 1031 exchange can allow you to hold on to the exchanged property’s full value. Instead, you could exchange your property for a few tenancy-in-common (TIC) interests. TIC interests are smaller interests in bigger properties. Doing a real estate exchange for TIC interests will both allow you to defer your taxes and have more options with your estate.
How do I get started with a 1031 exchange? 1031 exchanges are very complicated and require the expertise of a professional who can help guide you through the process. The SRG Advisors 1031 Exchange Program can help you start one today.
CTA: Looking for CPA help with a 1031 exchange? Contact SRG Advisors!