Understanding the Tax Benefits of 1031 Exchanges

As lucrative as real estate investing can be, Uncle Sam is right there to take his cut when it's time to reap the profits. As capital gains are taxed at the federal level at around 20%, they cut deeply into your earnings. By using a 1031 Exchange as an investment strategy, the IRS allows you to defer taxes on your gains if you reinvest the proceeds from a property sale into another property or portfolio of properties while meeting other requirements.

Basic 1031 Exchange Requirements

The requirements and regulations involved in various ways to do a 1031 Exchange can be overwhelming. In addition to localized property requirements, the type of property you are looking to swap may also affect the transaction. Though you should always consult a tax or legal professional, here are some of the basics.

      Identical Title Holder

The taxpayer selling one property must be the taxpayer purchasing the secondary property(s) involved in the exchange. If and when there is a delay between completing the transaction, a single-member limited liability company (SMLLC) or an Exchange Accommodator Titleholder (EAT) may serve as an intermediary for the interim, after which they will sell or transfer the title to the taxpayer.

• Time Constraints

Once the relinquished property(s) has been closed on, the taxpayer has 45 days in which time to identify the replacement property(s) to execute the 1031 Exchange. Secondly, after identifying the replacement property(s), the taxpayer has 180 days from the closing of the relinquished property to purchase its replacement without incurring a tax bill.

• Property Rules
• 1. The taxpayer may identify as many as three potential properties, regardless of value.
• 2. If the taxpayer has proposed four or more properties, their value cannot exceed 200% of the value of the relinquished property.
• 3. If the value of the identified properties exceeds the 200% threshold, then the taxpayer is required to purchase 95% of the identified properties.

• Property Values

To fully benefit from 100% tax deferment, the value of the relinquished property must be equal to or exceed the value, or debt, of the replacement property. Otherwise, a partial exchange will occur in which a tax burden may be incurred.

• Eligible Properties

Most investment real estate properties qualify for a 1031 Exchange. Eligible properties are referred to as "like-kind" use. The keys here are "real property" and "investment". For example, swapping a piece of commercial rental property for another or for a plat of vacant land designated for development is like-kind, and thus, eligible. The taxpayer's primary residence, however, would not qualify for a 1031 Exchange.

Reverse 1031 Exchange

Like the name suggests, in a Reverse 1031 Exchange, you purchase the replacement property before selling a property slated to be relinquished. There are some extra steps needed as compared to a "forward" exchange.

Since the IRS does not allow the taxpayer to hold title to both properties simultaneously at any point during the transaction, the aid of a third party or entity is required. To qualify for the exchange, a single-member limited liability company (SMLLC) or an Exchange Accommodator Titleholder (EAT) is required to camp title for the replacement property.

Once the property is secured through an EAT, the process and time requirements are as usual. You'll have up to 45 days to identify the property or properties (up to three) to be relinquished. You will then have a total of 180 days to sell the property(s) involved in the exchange AND to take legal ownership of the replacement property.

Benefits of 1031 Exchange

• 1. Tax and Ordinary Income Deferral - Deferring taxes allows you to reinvest the full amount of your proceeds and leverage them into a "like-kind" real estate investment.

• 2. It allows you to grow your investment portfolio. The law permits you to exchange it for "like-kind" investment but doesn't have to be a similar piece of property; it only needs to be "real estate".

• 3. Use the strategy to "swap up". You may have started with a small single-family house, but by trading the current market value, hopefully, appreciated, for another more valuable property. You can keep swapping until that small house has gotten you a string of houses or an apartment building.

• 4. The 1031 Exchange allows you to build equity over time—all tax-deferred. Strategically implementing a 1031 Exchange multiple times provides an instrument for the exponential growth of wealth. Additionally, when the time comes, those investments can be passed on to heirs which will reset the cost basis and virtually stamp out any tax liability.

Disadvantages of 1031 Exchange

• 1. It's not all gravy as tax-deferred is not the same as tax-free. If, at some point, you decide to dispose of your property(s), you'll face a tax bill for all 1031 Exchange properties.
• 2. Shouldn't be a surprise here, but the strict guidelines can get tricky. Any program where the government is offering tax deferment, one should expect plenty of bureaucracy and/or hefty penalties for non-compliant transactions.

• 3. There's a time limit in which transactions must occur. Generally, the new property needs to be identified with 45 days and closing needs to occur within 180 days.

• 4. If you don't reinvest all of your gains, the remainder, known as "the boot," becomes taxable capital gains.

• 5. You can't be sure what the capital gains tax will be at the time of sale if you defer your tax bill.

• 6. The flip side of deferring capital gains is the deferment of losses. Using losses to offset profits is a valuable tax strategy, but not being allowed to apply those losses to offset your tax bill can be costly.

• 7. "Like-Kind" means similar usage. You won't be able to sell an income-producing property and use a 1031 Exchange to purchase a new family home.

Using the 1031 Exchange is a strategic, albeit complicated, way to build an investment real estate portfolio by taking advantage of capital gains tax deferment. As the IRS is not in the business of providing free money, it can be a wise business decision to capitalize on the allowance offered. Though the basics have been discussed here, the intricacies that could affect your outcome are many; it is always best to consult a tax or legal professional to ensure full benefits are achieved.