What is a 1031 exchange and how does it work?
A 1031 exchange, also known as a like-kind exchange, is a tax strategy that allows investors to defer capital gains tax on the sale of an investment property by reinvesting the proceeds into a similar property. In this blog, we will explore the basics of a 1031 exchange and how it can be used to save on taxes.
Understanding Capital Gains and Depreciation Recapture
Before we dive into the details of a 1031 exchange, it is important to understand the basics of capital gains tax and depreciation recapture. Capital gains tax is a tax on the profit you make when you sell an investment property for more than you paid for it. The amount of tax you pay on the capital gains depends on how long you held the property and your tax bracket. Depreciation recapture tax is a tax on the depreciation previously deducted when a property that has been depreciated is sold. It requires taxpayers to pay a 25% tax on the amount of depreciation that was claimed as a deduction during the ownership of the property.
1031 Tax-Deferred Exchange Requirements
Now let's move on to the 1031 exchange. In simple terms, a 1031 exchange allows an investor to defer capital gains tax and depreciation recapture tax by reinvesting the proceeds from the sale of an investment property into another investment property. The new property must be of a similar type and have a similar use as the old property. There is some flexibility in terms of the types of properties that can be exchanged. For example, you can exchange a commercial property for a multifamily residential property or vice versa, as long as they are both held for investment purposes.
One of the most powerful uses of the 1031 exchange is that it can be used to defer taxes indefinitely if the investor continues to exchange properties throughout their lifetime. This can be a powerful tool for building wealth and increasing your real estate portfolio without the burden of paying capital gains tax or depreciation recapture each time you sell a property and keeping your chips on the table. When you pass away your heirs get stepped up to the new basis, and capital gains are never paid.
It is important to note that there are strict rules and regulations that must be followed in order to have a full or complete 1031 exchange:
Value: The acquisition price of the replacement property or properties must be equal to or greater than the sale price of the relinquished property or Properties. Ex: You sell a property for $1M. You cannot buy a property that then costs $800k if you want a full tax deferral.
Timing: There are two types of 1031 exchanges. A Froward Exchange and a Reverse exchange.
In a Forward Exchange, the investor must identify the replacement property within 45 days of selling the old property and must close on the new property within 180 days. These timelines run concurrently.
A Reverse Exchange is typically more complicated. In this exchange, the investor would need enough cash on hand to buy the replacement property first before closing on the sale of their relinquished property. These are more difficult to execute. In addition to having the cash on hand to close on the new property, the investor will need to have a lender that is willing to finance this ownership structure, as things can get a bit hairier with title and escrow. The timing on the reverse exchange is very similar to the forward exchange: 45 days to identify what property or properties you are going to sell and then 180 days to close on the sale. This runs concurrently starting on the date your purchase your replacement property. A reverse exchange takes the risk of identifying the property out of the equation and is a good tool if you have the cash on hand to acquire the replacement deal upfront.
Replacement Property Identification: Replacement properties identified must be “like-kind”. This means that this can only be done with rental (income) producing properties. This means that you can switch product types. An investor can go from a shopping center to an office or a multifamily property.
When in the identification period, you can identify up to three income-producing properties without any ramifications. There is no penalty for closing on only one of the three properties, and it is wise to identify all three properties in case your first choice falls through.
If you identify more than three properties and they exceed in aggregate value more than double the relinquished property’s value (what you sold the old property for), then you will need to close on 95% of the combined (aggregate) value of the replacement properties identified. In this scenario, you would need to close on 9.5 of the 10 properties – meaning, in all practicality, you will need to close on all of the properties you identified. This can be difficult if you do not have enough cash on hand to buy the additional properties.
Proceeds: The investor cannot receive any cash or other benefits from the exchange. Otherwise, they will be subject to capital gains tax on that amount.
Qualified Intermediary: A 1031 exchange must be done through a qualified intermediary. A qualified intermediary is a critical component of a 1031 exchange. This is a third party that handles the exchange of properties and ensures that all rules and regulations are followed properly. It is important to work with a qualified intermediary who has experience in 1031 exchanges and can provide guidance throughout the process.
A quick note on navigating the complexity of the 1031 exchange:
It is smart to be further along in the transaction of your identified property before you get towards the end of the 45-day identification window. An investor should not be identifying properties on the 44th day of the identification window still trying to find a deal that “might” work. There are a myriad of reasons for this. The main being that if you get into the due diligence or physical inspection and there is an issue, you may need to cancel the deal and the 1031 will blow up. A tip from our own experience is that once the earnest money is nonrefundable for the deal you are selling and you are confident the buyer will close, that is when you should begin looking for replacement properties. At this point the investor acquiring their 1031 replacement property should be in contact and upfront with brokers and let them know that they will be looking for a replacement property. The ideal scenario is to get the new property under contract prior to the sale of the relinquished property, but not too early to where the earnest money goes non-refundable on the deal you are buying before that of the deal you are selling.
1031 buyers who wait to identify a new property often fall into the trap of overpaying for that new property due to the pressure and time constraints of the exchange. Investors become so motivated by the tax deferral benefits of the 1031 exchange that they are willing to drop their criteria and buy a poor deal. You do not want to be the 1031 buyer that breaks the record for the lowest cap rate or highest price per unit. The key to avoiding this is to start looking early and lay the groundwork with owners and brokers to not end up in a position where you overpay for the replacement property.
Benefits of a 1031 Tax-Deferred exchange
Tax Deferral: One of the primary benefits of a 1031 exchange is that it allows investors to defer paying capital gains taxes and depreciation recapture when they sell an investment property and use the proceeds to purchase a new one. This means that investors can keep more of their profits and reinvest the full amount in another property since they have delayed paying their taxes.
Portfolio Growth: By using a 1031 exchange, investors can reinvest their profits into a new property and continue to grow their portfolio over time. This can help to increase cash flow, diversify the portfolio, and build long-term wealth.
Flexibility: A 1031 exchange allows investors to exchange a wide range of investment properties, including residential, commercial, and industrial properties. This gives investors the flexibility to adjust their portfolio as their investment goals and needs change.
Estate Planning: A 1031 exchange can also be used as a tool for estate planning. By deferring taxes and continuing to invest in new properties, investors can pass on a larger portfolio to their heirs, which can provide a valuable source of income and wealth for future generations. Additionally, when an investor passes away, the basis of their property is stepped up to the fair market value, which can result in significant tax savings for heirs. This means that the heirs will receive the property with a new, higher basis that is equal to the fair market value at the time of the investor's death. This can reduce or eliminate capital gains and depreciation capture taxes that would have been owed if the property had been sold.
Potential drawbacks to a 1031 Tax-Deferred exchange
Complex Process: A 1031 exchange can be a complex process that requires strict adherence to IRS regulations. Investors must work with a qualified intermediary and follow strict timelines to ensure that the exchange is completed properly. This can add to the complexity and cost of the transaction.
Limited Timeframe: A 1031 exchange must be completed within a strict timeframe. Investors have 45 days to identify a replacement property and 180 days to complete the exchange. If the deadlines are not met, the exchange may not qualify for tax-deferred treatment. This may also cause investors to overpay for the replacement property just to save on taxes. The losses on a bad deal can vastly outweigh the cost of paying taxes on the deal being sold.
Limited Flexibility: While a 1031 exchange provides flexibility in terms of the type of property that can be exchanged, there are limitations. For example, the property must be held for investment or business purposes, and personal residences do not qualify.
Reduced Depreciation Deduction: After executing a 1031 tax-deferred exchange, the taxpayer’s depreciable basis in the property will be less than if the property was acquired without a 1031 tax-deferred exchange. As such, there is a reduced depreciation expense over the life of the replacement property investment.
In conclusion, a 1031 exchange can be a valuable tool for real estate investors looking to grow their portfolio, defer capital gains tax on the sale of investment properties, and build long-term wealth. It is important to consult with a tax professional and a qualified intermediary to ensure that all rules and regulations are followed properly. By using a 1031 exchange, investors can continue to grow their real estate portfolio and defer taxes indefinitely.
Disclaimer
This article is provided for informational purposes only and should not be relied upon or deemed as investment, legal, or tax advice. Consult with your own investment advisor, legal counsel, accountant, and 1031 intermediary for advice concerning the topics contained in this article. Breneman Capital cannot be held responsible for any direct or incidental loss incurred by applying any of the information offered.