Frequently Asked Questions
The Frequently Asked Questions are meant to answer basic inquiries on 1031 Exchange transaction. Do take note that every 1031 Exchange is different therefore, we advise you to consult a competent Qualified Intermediary (QI), your Lawyer, and your Accountant/Tax Advisor to find the best structure to achieve your investment objectives. The application of these principles will depend on the data of each transaction.
The IRC 1031 Tax deferred has been around since 1921. It is a powerful way that allows you as the investment property owners to postpone the payment of capital gains taxes on the sale of investment property by reinvesting the proceeds into another investment property.
Under Section 1031, the Internal Revenue Code defines that "no gain or loss shall be recognized on the sale of property held for productive use in a trade or business or for investment purposes, if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or investment."
What is 1031 Exchange?
A 1031 Exchange is a transaction in which you, as Taxpayer / Property Owner, are allowed to sell one property and buy another without a tax consequence. This transaction is authorized by Section 1031 of the IRS Code and is the best strategy for postponing the payment of capital gains tax that would ordinarily arise from the sale of real estate. You pay the tax for the transaction some time in the future, usually when the property you bought has been sold. You are able to utilize 100% of the proceeds from the sale of your property (known as Relinquished Property) to purchase a new property (also referred to as Replacement Property). Basically, in a 1031 exchange, you basically do not pay for the federal income tax. Do take note it has its requirements and conditions.
What are the advantages of 1031 Exchange?
You can accomplish virtually any objective with 1031 Exchange, including greater control of your investment, various options for investing (diversification), improved cash flow, geographic relocation and/or property consolidation. You have the opportunity to increase your overall net worth by continuously compounding tax deferred dollars and leverage into higher valued property or properties. It is a powerful real estate investment-planning tool that allows you as investor to achieve investment goals.
Two major reasons to invest are financial leverage and strategic flexibility. In financial leverage, you receive an increase in available capital when the tax liability in a transaction is deferred. This capital can be used to acquire the replacement property. You gain financial leverage through an exponential increase in cash and appreciation - which results to your increase of buying power.
On the other hand, you can employ a number of tactics to increase strategic investment flexibility, by:
- Relocating your investment property closer to where you reside.
- Changing property types.
- Diversifying one into many for ease of future investments. This is when you exchange one larger property and opt to exchange it for multiple smaller properties in different geographic locations. It can be the other way around. You exchange multiple properties and consolidate into one larger property.
- Improving investment performance.
- Replacing older properties with newer ones.
Other benefits of exchanging are as follows:
- Reduction in management responsibilities when you exchange your apartments (management intensive property) to Triple Net Property or Tenant in Common Property (more passive type property).
- Improving your cash flow or appreciation potential when you exchange your land (non income property) for retail (income property).
- Retirement / Estate Planning - With some advance planning, you can exchange your investment property for a home or condo where you eventually plan to retire to. Upon the death of the Exchanger, the tax deferred gain that has compounded over the years will be wiped out, and the heirs will get a stepped up basis on the property inherited. To simplify, an older person can exchange an apartment building for two or three smaller properties to eventually leave for their kids to inherit upon death. We recommend you consult a tax or legal professional when planning for this type of exchange.
- Increase Depreciation Deductions - when you do an exchange, you increase the adjusted basis and tax deductions on depreciating asset. The amount of depreciation is calculated by the purchase price minus the deferred gain.
How does 1031 Exchange work?
A Qualified Intermediary (QI), like Easy 1031 Exchange of California, facilitates the transaction of a 1031 exchange.
1. You, as the Seller, will arrange for the sale of the property and you will include exchange intentions in the contract.
2. At closing, sales proceeds go to Qualified Intermediary (QI) for a 1031 Exchange.
3. You identify potential exchange properties within 45 days of the closing.
4. You complete 1031 exchange within 180 days of closing.
These steps can occur simultaneously. We suggest, but not require, that before you sell your property, you consider what type of replacement property will work best for you, and whether or not you want to own a whole or partial interest in a property.
Under Section 1031, the Internal Revenue Code defines that "no gain or loss shall be recognized on the sale of property held for productive use in a trade or business or for investment purposes, if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or investment."
What is a tax-deferred exchange?
A tax-deferred exchange is a way by which you, as the Property Owner, trade one or more of your property for one or more replacement properties of "like-kind", while postponing the payment of federal income tax and some state taxes on the transaction. Usually, you are taxed on any gain realized from a sale, right? In this case, through Section 1031 Exchange, the tax on the gain is deferred until some future date.
The theory behind 1031 Exchange is that when you have reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. It means that your investment is still the same, only the form has changed (vacant land to apartment building). Thus, it would be unfair to pay tax. One common hope of the government is to ultimately receive tax revenue. It is an assumption that you are willing to dispose of and acquire other property when there is a tax deferred exchange. This means that more business owners and investors are replacing worn or inadequate properties without incurring large capital gains tax. As a result of these reinvestment activities, more people are employed, who, in turn, employ others through their spending. This cycle brings in additional income tax for the government.
Please take note that the exchange of properties is tax deferred, not tax free. When the replacement property is ultimately sold (that is, its not part of another future exchange, which you can do in the future), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
What tax is deferred in a Section 1031 Exchange?
Capital gains tax has two (2) components: the tax due on the profit earned on the sale of the investment or income property AND the tax due on the recapture of deprecation previously taken by the taxpayer during the time the taxpayer owned the property.
Under Section 1031, the Internal Revenue Code defines that "no gain or loss shall be recognized on the sale of property held for productive use in a trade or business or for investment purposes, if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or investment."
What are the requirements for a valid exchange?
Both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment.
Excluded from Section 1031 Exchange: property for sale; inventories; stocks, bonds, or notes; other securities or evidences of indebt ness; interest in a partnership; certificate trusts or beneficial interest. In general, if property is not specifically disqualified, it can be included for tax-deferred treatment.
You cannot change into or out of personal residence. If your vacation homes are not rented out, then it may not qualify for 1031 Exchange.
Replacement property acquired must be like kind to the property being relinquished.
The relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property.
The investor must meet these value requirements:
1. You as Taxpayer must reinvest all your net equity proceeds into the replacement property.
2. Purchase replacement property(ies) that is equal or greater than the net sales price of the relinquished property.
3. Obtain equal or greater debt on the replacement property. Additional cash from the Exchanger can offset the debt, however, increasing the debt cannot offset a reduction in cash equity.
Most deferred exchanges are facilitated by Qualified Intermediaries who will assist you in meeting the requirements of Section 1031.