What is a 1031 Exchange (And How Does It Work)?

How would you like to build your personal wealth faster?

If you’re taking advantage of the burgeoning real estate market, you may be wondering how to scale up without getting penalized by Uncle Sam.

Between income generation and appreciation, real estate can build lasting wealth more reliably and consistently than other investments. But how do you grow your portfolio in the most cost-effective way?

Read on to find out how a 1031 Exchange can help you invest in income-generating properties on a larger scale than before.

What is a 1031 Exchange?

A 1031 Exchange, sometimes called a “like-kind” or Starker exchange, allows you to sell an investment property and defer the capital gains tax to invest in a replacement property.

Depending on your income, capital gains can strip you of as much as 20% of the profit from your investment.

Here’s a quick summary of the various types of 1031 exchanges.

1. Simultaneous Exchange

A 1031 Exchange can be a real swap of properties: Two investors simply swap properties of equal value with neither paying the tax. This isn’t a common occurrence, however.

2. Delayed Exchange

A delayed exchange lets you sell your property and then find another one to purchase, while still deferring the tax. In a delayed exchange, you have 45 days to find and identify a new investment property and up to 180 days to close the sale.

3. Reverse Exchange

If you have cash for your next investment, you can do a Reverse Exchange and still defer the capital gains tax. In this case, you purchase your new investment before selling the old one.

The benefit is the same — you can still defer the capital gains tax. On the downside, you have to have the cash upfront and need to sell the original property within the 180-day window.

1031 Exchange Rules 2020

Like any process under the auspices of the IRS, there are a few important 1031 Exchange rules. There are also some newer restrictions.

1. Equal or Higher Value

The most important of the 1031 Exchange rules applies to the value of the properties. The new property must be of equal or higher value than the property sold.

2. Like-Kind

To qualify for the deferment, both properties must be of “like-kind.” That means similar in nature, such as swapping an apartment complex for a rental duplex.

You can even exchange one apartment building for two single-family homes, as long as the newly acquired properties together are of equal or higher value and both are used as investments.

New Rules

New regulations limit the type of exchanges acceptable under 1031.

Previously, deferments applied to the sale of businesses and non-real estate assets. The like-kind rule meant that you could only exchange a business for a business or real estate for real estate.

As of January 1, 2018, however, tax deferrals are only available for like-kind real estate exchanges under 1031.

3. Same Tax Payer Rule

To comply with 1031, the taxpayer must be the same on the old property as on the new one. There is a handy workaround, however, for sole-proprietor LLCs. If you were the sole owner of a property, you can transfer the replacement property to your sole proprietor LLC.

4. Qualified Intermediary

In order to qualify for a 1031 Exchange tax deferment, the capital from the sale of the original property must be held by an independent third party, called the Qualified Intermediary or QI.

Generally, this is a fiduciary firm that holds the proceeds on account, similar to an escrow account. Once the purchase property has been identified, the QI will disperse the funds at closing.

What are the Benefits of a 1031 Exchange?

When you do an exchange, you can defer the capital gains tax on any investment property you sell and invest them into expanding your portfolio. This gives you more equity in your new investments.

If you’re considering getting into the house-flipping game, following the 1031 Exchange rules can keep more of your money working for you.

A 1301 Exchange also allows you to take advantage of real estate trends. If the market in your current investment has leveled out, you can sell and invest your money into property in an up-and-coming neighborhood.

You can also change the nature of your investment without getting penalized by the capital gains tax. You can take on new business opportunities, such as selling one of your single-family rentals to purchase vacation rentals.

How Does It Build Wealth?

By deferring the capital gains tax on the sale of your investment properties, you retain more equity in your purchase. So, when it’s time to sell your property, you’ll see more cash on the table.

That can be a critical difference if you rely on mortgages to invest in real estate. The amount of interest you pay the bank is based on how much you borrow, not on the sale price. So, if you can walk into new investments with more money upfront, you’ll save on financing.

And if you’re building a portfolio of income properties, deferring capital gains taxes lets you scale up in doable increments. With more money down, you can widen your net when it comes to buying new properties.

So, When Do You Pay Tax?

Nothing good lasts forever, so, of course, you’ll eventually pay taxes. Internal Revenue Code, Section 1031 allows you to defer the payment of capital gains taxes until you sell the replacement property.

You may also pay it with increased income taxes as part of depreciation recapture if you’ve been using depreciation as a deduction. Should you sell the property for more than the depreciated value, the difference becomes taxable income. This is calculated separately from your capital gains tax.

Capital gains taxes may also come due as a tax on an estate after the owner’s death.

Simple Steps for a 1031 Exchange

The process seems overwhelming, but you can break it down into a few simple steps:

Market and sell your existing investment property
Entrust your gains with a QI
Find a like-kind investment property within 45 days
Make an offer on the new property and negotiate a contract
Have your QI disperse funds to the seller of the replacement property
Fill out a Form 8824, Like-Kind Exchanges, for the IRS

Money Bags Only?

You don’t have to be a real estate mogul to take advantage of the 1031 Exchange tax deferment rule. Between 2011 and 2014, 48% of 1031 transactions involved individual investors.

The 1031 like-kind Exchanges is perfect for small business and investors. The ability to re-invest what would have gone to the IRS can provide real purchasing power while building your portfolio.

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