1031 Strategies

A 1031 Exchange is a transaction under United States law which specifies that if an asset (such as real estate, including land or a building) is sold and the proceeds of the sale are then reinvested in an asset of a similar kind (like kind asset), then no capital gain or loss is recognized, allowing the deferment of capital gains taxes that would otherwise have been due on the first sale. This law is defined under section 1031 of the Internal Revenue Code, 26 U.S.C. § 1031.

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1031 Strategies

1031 Exchanges

What is a 1031 Exchange?

A 1031 Exchange is a transaction in which a taxpayer is allowed to sell one property and buy another without a tax consequence. This can be done through a simultaneous or delayed 1031 Exchange. The transaction is authorized by Section 1031 of the IRS Code. It is the best strategy for the deferral of capital gains tax that would ordinarily arise from the sale of real estate.

A successful exchange results in the taxpayer being able to utilize 100% of the proceeds from the sale of property to purchase a new property, thereby deferring capital gains taxes. Real Estate owners can accomplish virtually any objective with 1031 Exchanges, including greater leverage, diversification, improved cash flow, geographic relocation, and/or property consolidation.

How does it work?

A 1031 Exchange is usually a three-way delayed exchange, referred to as a "Starker Exchange", in which an intermediary is used to facilitate the transaction. There are four basic steps:

Seller arranges for sale of property and includes exchange language in contract. At closing, sales proceeds go to a Qualified Intermediary for a 1031 Exchange. Seller identifies potential exchange properties within 45 days of the closing. Seller completes 1031 Exchange within 180 days of closing.

In a 1031 transaction, these steps can also occur simultaneously. Preferable, before you sell your property, you need to 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. Increasingly, investors are choosing to purchase a partial Tenants In Common interest for several reasons.

Advantages of Undivided Tenants in Common Interest Ownership

It is often difficult in the short 45-day time frame to locate a property that has the right purchase price, debt ratio, and closing schedule to meet the 1031 exchange requirements-and then arrange any financing that may be necessary. A Tenants in Common ownership interest has a number of advantages, such as

  • Flexible size to match your needs
  • Pre-arranged financing
  • No management hassles
  • Potential for increased after-tax cash flow
  • Economies of sale
  • Can be identified and closed in a timely manner
  • Investment can often be diversified into more than one property
How will a Tenants In Common 1031 Exchange benefit me?

You may own management-intensive real estate. Although you are comfortable with real estate investments and have had good returns in the past, you do not like the daily headaches that can accompany real estate management. You are ready to give up the hassles of dealing with tenants, maintaining facilities, paying property taxes, etc. You would like to sell your property but are faced with onerous tax consequences on the sale. You'd rather enjoy the income from the property and let someone else manage it. With a TIC 1031 Exchange, you can do exactly that.

A TIC 1031 Exchange allows you to exchange your management-intensive property for an institutional-quality property with the potential to generate steady income, tax benefits and appreciation. With a TIC 1031 Exchange, you no longer have to feel burdened by your real estate. Through your management contract, a manager will be retained to manage the asset while you enjoy all the benefits of income property ownership-and freedom from management duties.

Your income from the replacement property may be higher than what you were receiving from the original property. You can earn substantial cash flow that may be up to 60% sheltered by the depreciation of your new basis in your TIC purchase.

No capital gains taxes may be due until the replacement property is eventually sold. If you shuffle off this mortal coil while owning a property, your heirs will receive a stepped up basis and the capital gains tax will be completely avoided.

How do I get started?

Discuss your specific needs with your registered representative who will be happy to answer your questions and provide you with the information you need to consider a 1031 Exchange.

1031 Terminology

Like-Kind Property

Like-Kind refers to the type of property being exchanged. You can exchange any real estate investment for any other type of real estate investment - for example, vacant land can be exchanged for rental property. In most cases your personal residence is not Like-Kind investment property.

Exchanging Up

To accomplish a fully tax-deferred exchange, the rule of thumb is "exchange even or up in value; exchange even or up in equity and in debt."

Boot
To the extent that you do not exchange even or up in value and/or exchange even or up in equity and debt, you will have received non-qualifying property ("boot") in your exchange. If boot is received, tax is computed on the amount of gain on the sale or the amount of boot received - whichever is lower.

Typical Exchange Addendum Language for Sales Contracts: "Buyer hereby acknowledges that it is the intent of the Seller to effect an IRC Section 1031 tax deferred exchange which will not delay the closing or cause additional expenses to the Buyer. The Seller's rights under this agreement may be assigned to a Qualified Intermediary, named by Seller, for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and the Qualified Intermediary in a manner necessary to complete the Exchange."

 

1031 Do's and Don'ts

DO advanced planning for the exchange. Talk to your accountant, attorney, broker, financial planner, lender and Qualified Intermediary.

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. 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 cash.)

DO NOT try to do a 1031 exchange yourself using your CPA or attorney to hold title or funds. IRS regulation requires a Qualified Intermediary to property complete an exchange. Call us for the name of one that operates in your area.

DO attempt to sell before you purchase. Occasionally exchanges find the ideal replacement property before a buyer is found for the relinquished property. If this situation occurs, a "reverse" exchange (buying before selling) may be necessary. Exchangers should be aware that reverse exchanges are considered a more aggressive exchange variation because no clear IRS guidelines exist.

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.