A 1031 exchange allows an investor to swap one business or investment asset for another without recognizing a capital gain. This can be a “smart swap,” allowing an investor to grow a portfolio, increase the rate of return, and defer capital gains taxes on the property sale. The number of 1031 exchanges an investor can make are unlimited, but be aware specific rules apply. With today’s low interest rates, this is a great time to consider a 1031 exchange, sometimes referred to as a “Like-kind Exchange.”
1031 exchanges are complicated, so you may want to work with a professional. Here are a few things you should know.
- Like-kind is flexible. One of the basic requirements to qualify for a 1031 exchange is that the two properties must be “like-kind.” When the asset being sold or “exchanged” is real estate, “like-kind” is a broad term that allows individuals to exchange investments that are perhaps not as similar as you might think, like a multi-family residence for a strip mall.
- Timing is everything. In order to be successful in a 1031 exchange, you must close on the new property within 6 months of the sale of the old. From the day your sale closes, you have 45 days to designate up to three replacement properties and an additional 145 days to close the purchase of the selected replacement property. Beware of the cash tax. If have left over cash after the intermediary acquires the replacement property, the cash will be taxed as partial sale proceeds and considered a capital gain.
- Not for your principal residence. The 1031 provision is meant only for investments and business properties. No primary residential properties qualify; however, in some cases, the tax deferral can be used for the sale of a vacation home.
- Some personal property exceptions. Certain personal property can qualify for a 1031 exchange. Defining what does and doesn’t qualify is complicated and can be confusing. For example, corporate stock or partnership interests don’t qualify, but a painting may. Because the requirements are complex, it’s best to work with a professional throughout the process.
- Beware of the cash tax. If there is cash remaining after the intermediary acquires the replacement property, the cash will be taxed as a partial sale and the proceeds will likely be taxed as capital gains.
- Section 1031 Defers Taxes. A “like kind exchange” permits an investor to defer taxes; when the replacement property is later sold, the taxes will have to be computed and paid.
Here is an example of a 1031 exchange that may benefit an investor. An investor has owned an office building for 20 years and the building has no mortgage. The building was purchased for $200,000 and is now worth $1,500,000. After operating expenses, taxes and other expenses, the investor receives $4000 a month in rental income or $48,000 a year, an annual rate of return or 3.2%. If the investor sells the office building for $1,500,000 and exchanges it for a newer property of equal or greater value, he or she may be able to achieve rents that have a substantially higher rate of return. This is a “smart swap.” A 1031 exchange is appropriate when the investor will receive greater appreciation while maximizing depreciation, and increasing cash-flow. In the circumstances described above, if the investor sold the office building for $1,500,000 and paid federal and state taxes at a combined 30% rate on the gain of $1,300,000, he or she would have only $1,100,000 to reinvest.
If you are you interested in a 1031 exchange, contact us today.