1031 Tax-Deferred Exchange
1031 Tax-Deferred Exchange Overview
A 1031 exchange is basically a property swap that allows you to defer any capital gains tax liability generated from selling an investment property for a profit. The name is taken from Section 1031 of the Internal Revenue Code. Exchanges have been successfully completed since the early 1920s, although today they are limited strictly to real property assets that have been held for investment purposes or used in business and trade.
In a straight sale, investors who divest appreciated real estate generate an immediate tax liability when the asset sells for more than its adjusted cost basis. However, by executing a 1031 exchange – rolling over the entirety of sale proceeds from the relinquished property into a like-kind replacement asset – you are allowed to defer capital gains and depreciation recapture taxes. The exchange process can continue indefinitely – you can keep swapping investment properties until you die, and if you’ve bequeathed an exchange property to your heirs, they will receive a one-time step-up in basis to fair market value that may potentially wipe out any rolled-over tax liabilities.
If you decide to sell a property you acquired to complete a 1031 exchange, however, those deferred capital gains taxes come due.
Basic 1031 Exchange Do's & Don'ts
DO advanced planning for the exchange. Talk to your accountant, attorney, broker, financial planner, lender and Qualified Intermediary prior to exchanging.
DO NOT miss your identification and exchange deadlines. Failure to identify within the 45 day identification period or failure to acquire replacement property within the 180 day
exchange period will disqualify the entire exchange resulting in the sale of the downleg property being fully taxable. Reputable Intermediaries will not act on back-dated or late identifications.
DO keep in mind these three basic rules to qualify for complete tax deferral:
• Receive only “like-kind” replacement property.
• Use all proceeds from the relinquished property for purchasing the replacement property.
• Make sure the debt on the replacement property is equal to or greater than the debt on the relinquished property. (Exception: A reduction in debt can be offset with additional cash; however, a reduction in equity cannot be offset by increasing debt).
DO NOT try doing a 1031 exchange using your attorney or CPA to hold title or funds. IRS regulation requires a Qualified Intermediary or Accommodator to properly complete an exchange. Call us for the name of one that operates in your area.
DO remember tax laws are subject to change which may have a negative impact on a 1031 exchange.
DO NOT dissolve partnerships or change the manner of holding title during the exchange. A change in the Exchanger’s legal relationship with the property may jeopardize the exchange. There are some options related to retitling, please call us to discuss.
DO remember these investments are not suitable for all investors.
Benefits of a 1031 Exchange
• Increased Income Potential – Exchangers can sell raw land and acquire income producing property, such as a rentable building.
• Leverage - When an exchanger sells their property, they can potentially increase their income by reinvesting all of the gains.
• Change Property Types – Exchanges allow proceeds to be invested into different types of investment real estate.
• Selling Power - Exchangers do not have to inflate the selling price to cover capital gains taxes that would normally be due upon the sale of the investment property.
• Consolidate Portfolio – Exchangers can sell multiple properties and exchange them for a single property.
• Improved Income Tax Treatment – Exchangers can invest in properties that may have increased depreciation deductions resulting in overall reduced taxable income.
• Estate Planning – An investor can perform exchange after exchange, the tax liability of which could be forgiven upon the death of the investor based on the current tax laws.
Risks of a 1031 Exchange
- No guarantee - There is no guarantee that any strategy will be successful or achieve investment objectives.
- Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments.
- Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
- Potential for foreclosure – All financed real estate investments have potential for foreclosure.
- Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions.
- Impact of fees/expenses – Costs associated with the transaction may impact investor's returns and may outweigh the tax benefits.
- Stated tax benefits – Any stated tax benefits are not guaranteed and are subject to changes in the tax code. Prospective investors should consult with a financial advisor, attorney and/or tax advisor regarding a 1031 exchange before selling a property.