Exploring the Benefits of 1031 Exchange
In today’s market, a lot of real estate investors are considering taking advantage of selling their property in a highly appreciated market. However, sometimes investors deter their decisions due to the looming tax bill on the other end of the sale. If you own an investment property and are looking to find a way to defer your taxes when you sell it, you should consider the benefits of a 1031 Exchange.
A 1031 Exchange allows you to defer capital gains tax which will then free up more capital that can be used to buy an alternative property. This is permitted because you are rolling over the gains from the first property into the next.
The Benefits of 1031 Exchange in Numbers
The two simple rules for completing a 1031 exchange are:
1) Equal and up in equity (spend all of your proceeds)
2) Equal and up in value.
This is a simple example of a straightforward 1031 exchange through the eyes of a property owner.
- You sell your relinquished property for $500,000
- You paid off a mortgage of $100,000 at closing
- This gives you $400,000 of equity and $100,000 of debt that has to be replaced
- You find a replacement property for $500,000
- You can either get a new mortgage for $100,000 or add capital to your exchange
- An important rule is that you can always use cash to replace debt, but you cannot use debt to replace cash. This could create what we would call “mortgage boot.”
Some Requirements Needed For the Benefits of 1031 Exchange
These steps can be covered in greater detail, but the following bullet points give you the basics to understanding what you need to know:
- As a seller, the most critical item is that you DO NOT take constructive receipt of any proceeds at closing. Any monies you are looking to defer the taxes must be sent to a disinterested third party, otherwise known as a qualified intermediary (QI).
- The property you buy must be equal to or greater than what you are selling. If not, you will owe taxes on the difference. This is also known as “boot.” They must also be “like-kind properties, ” meaning they must be held only for business or investment purposes and not for private use.
- When you sell your old property, if you and your legally recognized spouse are on the title, you both need to be on the new one as well. The same rule applies if it is a corporation selling and buying. All 1031 exchanges must be executed under the same taxpayer.
- Your entire exchange period is 180 calendar days. This counts weekends, holidays, and your birthday! Within this 180-day period is your identification period. This is the first 45 days of the 180-day period. After your identification period, you will have an additional 135 days to close on your new property.
- Within 45 days of the closing date of the original property, you must have any potential replacement properties identified. The most common rule used is called the 3-property rule. You can choose up to three properties and use the 200% rule or the 95% rule for your identification options. Any properties that are not listed on your identification form will not be eligible for your 1031 exchange.
Who Generally Utilizes the 1031 Exchange?
Contrary to what some believe, this is not some tax “loophole” for wealthy real estate owners. Section 1031 dates back to 1921 and has been part of our internal revenue code since! All real estate owners that own investment or business use property can be eligible to take advantage of this opportunity; many times, it is Mom & Pop investors or small business owner who does.
Your Financial Advisor Can Walk You Through The Steps
1031 Exchanges follow a strict timeline and are pretty complex. Any real estate investors considering this option need to surround themselves with the appropriate professionals to help make their 1031 exchange as smooth as possible.
RVPII Consulting works with real estate investors to help guide their 1031 exchange transactions and ensure their investment decisions align with their financial goals. In addition, our firm offers passive investments for accredited investors that are eligible for 1031 exchanges as well!