What is a 1031?
A 1031 Tax-Deferred Exchange allows you to preserve the value of your property investment and can be a powerful tool if administered correctly. A tax-deferred exchange under Section 1031 of the Internal Revenue Code allows the real estate investor to sell an investment property and acquire another ‘like-kind’ property while deferring federal capital gains taxes until later. This lets you reinvest sale proceeds that would otherwise be paid to the government as capital gains taxes.
STEP 1 - Owner sells investment property and enters into a Purchase Contract that obligates the
buyer to cooperate closing the transaction as a Section 1031 Exchange with the help of a Qualified Intermediary. (QI)
The Relinquished Property Purchase Contract should contain a "cooperation clause" which obligates the buyer to cooperate with you in structuring the transaction as a Section 1031 Exchange.
STEP 2 - DIS will assist you in finding a qualified intermediary, with whom you'll open an account to transfer the proceeds from the sale. Exchanger must not take possession of the funds or their exchange will be disqualified.
STEP 3 - Seller (exchanger) of the property identifies replacement properties within 45 days of sale and notifies the QI by midnight of the 45th day.
STEP 4 – Remember the closing must occur within 180 days of the closing on the relinquished property (or by your tax return due date, if earlier), or the exchange won’t qualify for Section 1031 treatment.
It should be noted that for an exchange to be 100% tax deferred, the exchanger (investor) must acquire a replacement property that is of equal or greater value and equal or greater in debt (loan) and spend all of the net proceeds from the relinquished property. Any reduction would be "boot." Boot is defined as any non-‘like-kind’ property received by the exchanger in the exchange and it is taxable. Boot can be cash received from the sale of the relinquished property or other non-cash consideration, including any property that is not ‘like-kind,’ promissory notes, or debt relief. If you receive boot in an exchange, it is likely that all or some portion of the boot will be taxed. See below for 1031 Exchange FAQ for additional information on Boot.
IMPORTANT NOTE: Exchanger has 45 days to identify replacement property(ies) and must close on the replacement property(ies) within 180 days from the close date of the property that was sold.
To find out more 1031 Exchange basics, contact DIS’s comprehensive team of tax advisors, attorneys, Real Estate Brokers, FINRA registered representatives and registered investment advisors. Click here for a complimentary consultation or call 866-261-0104.
On January 1, 2013, a new 3.8 percent tax on some investment income went into effect. This tax is not imposed on all real estate transactions, but it may impose a 3.8 percent tax on some (but not all) income from interest, dividends, rents (less expenses) and capital gains (less capital losses). The tax will fall only on individuals with an adjusted gross income (AGI) above $200,000 and couples filing a joint return with more than $250,000 AGI.
Investors should also note that the Federal Capital Gains Tax has increased from 15 to 20 percent and California Capital Gains Tax currently stands at 9 percent plus the 3.8 percent tax if an exchange does not take place. Combined, these taxes total 32.8 percent not including depreciation recapture. Smart investors take into consideration the positive tax ramifications of a 1031 Tax Deferred Exchange strategy to strengthen their portfolio and their finances. Click here for N.A.R. report on 3.8% tax.
More to Invest.
Because federal income taxes are deferred, the exchanger has greater leverage than if the tax liability was paid. The additional equity available for the reinvestment can also assist the exchanger in obtaining more financing, if needed.
Exchanges such as a DST, 721 UPREIT and Triple Net NNN offer investors the opportunity to exchange from active ownership properties into a passive ownership property allowing them to own income property with little to none day-to-day management responsibilities.
One property can be exchanged into many properties through Delaware Statutory Trust (DST) and 721 UPREIT ownership properties as well condo, single-family, multi-family, Triple Net NNN Investments, Commercial, etc. (Diversified Real Estate Advisors can help you find a local investment property) offering potential asset diversification of hundreds of properties.
DIS’s experienced and inclusive team of advisors will analyze each investors’ unique situation and develop a diversified plan that is structured to take advantage of varied asset classes, geographical boundaries, tenant mix and liquidation events.
However, there are no assurances that diversification will produce profits or guarantee against loss.
Greater Earning Potential.
Since more of the capital is reinvested than would be the case if taxes were paid, there is the opportunity for greater earning potential for the investor.
Exchange after exchange can be done creating a positive compounding effect by reinvesting the additional deferred taxes on each subsequent exchange. The deferred tax liability can ultimately be forgiven upon death of the investor, giving heirs a stepped up basis on inherited property.
The investor may experience greater pricing flexibility because the sale price of the relinquished property will not need to be inflated to cover capital gains taxes. This enables the seller to have increased flexibility with the selling price.
The possibility to trade up to larger and higher quality properties by utilizing DST, NNN, ‘Triple Net’ and 721 UPREIT investments may offer opportunities for the investor to trade up to better quality institutional real estate.
Many management intensive properties may be consolidated into properties that require less management. By utilizing the structure of a DST, NNN Triple Net or 721 UPREIT type of investment, many management intensive properties may be consolidated into properties that require less management.
Why now may be a good time to consider a 1031 Tax-Deferred Exchange:
As part of the new healthcare bill, a 3.8 percent surcharge on certain investment income went into effect January 1, 2013. Federal Capital Gains Tax increased from 15 to 20 percent. Combined, these taxes could raise rates on capital gains for upper bracket households up to 32.8 percent. As a result, some investors with rental properties may consider Section 1031- tax-deferred exchanges as a way to protect their profits.
Examples of real estate scenarios regarding the 3.8% tax is available in an informative pdf prepared by the National Association of REALTORS©.
To find out more about the benefits of a 1031 exchange, contact DIS’s comprehensive team of tax advisors, attorneys, Real Estate Brokers, FINRA registered representatives. Click here for a complimentary consultation or call 866-261-0104 or click here.
Why do I need a Qualified Intermediary?
A Qualified Intermediary is necessary to create the exchange of properties required under section 1031. A Qualified Intermediary simplifies the exchange process by accepting a transfer of your property, conveying it to the buyer, taking custody of the proceeds, buying the replacement property, and transferring title to you. It is a sensitive role requiring experience, special knowledge, and extreme care to preserve the tax-deferred character of the transaction.
Can anyone serve as a Qualified Intermediary?
No. There are certain persons who may not act as your Qualified Intermediary. Generally these include relatives, or someone who within a two-year period prior to your exchange, has acted as your attorney, accountant, real estate broker or agent. It is important to select a reputable Qualified Intermediary and we are happy to refer you to some of the title companies with subsidiary QI companies. Click here for referral to a Qualified Intermediary.
What characteristics should my advisors and I look for in selecting a Qualified Intermediary?
Experience, financial stability and customer satisfaction are factors that you should consider. Diversified Investment Strategies will assist you in selecting a reputable Qualified Intermediary.
If I select a Qualified Intermediary, do I still need a legal or tax advisor?
Qualified Intermediaries are appointed to carry out the exchange and prepare the necessary documentation for tax-deferral; Qualified Intermediaries are precluded from counseling you on the desirability or tax implications of an exchange.
How do I identify a replacement property?
The identification of a replacement property must be submitted in writing, clearly described, and signed by you, and must be delivered or sent before midnight of the 45th day from the date of the transfer of your relinquished property. Diversified Investment Strategies will assist you with this requirement.
What happens if I change my mind about buying a replacement property and want to cancel my exchange?
If you transfer the relinquished property and do not replace it with another, the sale will create a taxable event and any capital gains will be subject to federal and state capital gains taxes.
What happens if I sell a property and then decide I want to make it a part of a tax-deferred exchange?
If you actually or constructively received proceeds from the sale, it might not be possible to include that property in a tax-deferred exchange. That's why it's important to note your intention to make this transaction a part of a tax-deferred exchange in the contract to sell the relinquished property. If you have entered into a contract to sell, but have not closed, it may be possible to carry out a deferred exchange, provided you execute the proper exchange documents, identify the replacement property within 45 days of the closing, and actually receive it within 180 days or before your tax return is due. Your attorney or tax advisor can help you make this determination.
Do I need to do a tax-deferred exchange for my personal residence?
No, your personal residence is not considered property held "for productive use in a trade or business" or "for investment," and therefore does not meet the requirements of section 1031. However, Internal Revenue Code Section 121 allows an individual to exclude from taxation up to $250,000 of the capital gain realized on the sale of the individual's principal residence. Married couples filing jointly can exclude up to $500,000.
Do I have to spend all of the proceeds from my relinquished property on replacement property?
No you do not, however you will be taxed on the amount you don't spend. Unused proceeds are known as "boot" and are taxed on their face value at the capital gains tax rate.
If I don't spend all of my proceeds when can I receive the unused amount?
You can receive unused proceeds at any time after you have acquired each one of the properties identified within your 45-day identification. If you do not acquire all of the properties identified within the 45-day identification, then the unused proceeds cannot be released until the due date of your tax return, including extensions, or 180 days after the closing of the sale of the relinquished (exchange) property.
Can I combine multiple relinquished properties into one replacement property?
Yes, you can combine multiple relinquished properties into one replacement property. The rule here is that the first relinquished property to close starts the clock running for all the rest. All the relinquished properties to be combined must be closed within 45 days of the first one to close. The same replacement property is then identified for each relinquished property to be combined. Treas. Reg. 1.1031(k)-1(b)(2)(ii).
If the replacement property is a rental, how long does it have to remain a rental before it can be converted into a primary residence?
There are no hard rules here. The IRS requires that you show intent to use the replacement property as a rental.
Most of the tax attorneys that we have discussed this with believe that if the property shows up as a rental on two or more consecutive tax returns you will have shown intent.
If the replacement property is sold, how are the capital gains taxes calculated?
The capital gains tax is calculated the same as in any other sale, assuming that you have not converted it to residential use, and that you are not going to do another 1031 exchange.
The trick here is to be able to establish the basis on the new property at the time of sale. The basis on the new property is the sum of the basis transferred from the old property, plus the difference between the sale price of the old relinquished property and the new replacement property, minus the depreciation on the new replacement property.
What is Internal Revenue Code "Section 1031"?
Section 1031 of the Internal Revenue Code relates to the disposition of property that is held for use in productive trade or business or held for investment. If performed properly, code Section 1031 provides an exception to the rule requiring recognition of gain upon the sale or exchange of property. In other words, if the requirements of a valid 1031 Exchange are met, capital gain recognition can be deferred until the taxpayer chooses to recognize it. The current Federal tax rate (maximum) on long term capital gains is 32.8%, plus any applicable state taxes. Long term capital gains are not taxed as ordinary income. For an exchange to be 100% tax deferred, the Exchanger must acquire replacement property that is of equal or greater value and spend all of the net proceeds from the relinquished property. Many specific requirements must be satisfied in order to complete the exchange properly. With the recent IRS Regulations in place, an experienced qualified Broker, Intermediary and Escrow/title officer can accomplish an exchange with ease.
How do I know if my transaction is a 1031 Exchange?
The best way to confirm if you have an exchange is to ask the principals involved. Here are some helpful hints to determine if someone may want to perform an exchange:
- Is the property the seller’s residence?
If yes, then the seller will not be eligible for a 1031 Exchange.
- Does the buyer intend to live at the property?
If yes, then the buyer will not be eligible for a 1031 Exchange.
- Is the property intended for investment purposes?
If yes, then either the seller or buyer might want to perform a 1031 Exchange.
Why is it important that a real estate broker or agent understand exchanging?
In today's real estate market, it is imperative that real estate brokers and agents understand the options a 1031 Exchange can offer their clients. Without such knowledge, brokers and their agents are open to potential liabilities. Unfortunately, brokers can be as liable for what they don't say, as well as for what they do say. Simply offering the option of a tax-deferred exchange can eliminate potential liability on the broker's part. The "exchange agent" can have more satisfied clients by offering them the option to save substantial tax dollars through exchanging. The exchange agent can also increase their income with the additional knowledge of exchanging.
What is "like-kind" property?
The IRS Code Section 1031 states that property held for use in productive trade or business, or property held for investment is potentially exchangeable. One can therefore qualify for non-recognition of gain upon the disposition of such property, assuming all other requirements are met. This means that a business property or property held for investment, may be disposed of to a buyer (sold), set up with a Qualified Intermediary and put into escrow, (documenting the transaction as an exchange), and within the codified time frame, repurchase replacement property of "like-kind" – thereby completing the exchange. It is not required that exactly the same type of property be acquired. In 1989, the IRS attempted to change the meaning of "like-kind" to "similar use", and unfortunately, many people believe that is the case. The attempt was defeated. "Like-kind" property that can be exchanged under the current meaning of Code Section 1031 can include: PROPERTY THAT IS HELD FOR PRODUCTIVE USE IN A TRADE OR BUSINESS, OR, PROPERTY THAT IS HELD FOR INVESTMENT. "Like-kind" property can include, but is not limited to, any of the following provided it is held for investment: commercial, single family rental property, condos, raw land, apartments, vacation homes, second homes, duplexes, industrial properties and a leasehold interest of 30 years or more.
A person's PRIMARY RESIDENCE does NOT come under the rules of Section 1031, and is specifically EXCLUDED, as is property held "primarily for resale" or dealer property.
A common misconception to "like-kind" is that the properties being exchanged be of "similar use". This is simply not true. For example: A commercial property can be exchanged for an apartment complex or bare land exchanged for a single-family rental.
Why exchange property instead of just selling it?
The most important reason is to be able to defer potentially taxable gain realized from a sale of a property. A seller may be able to use All OF THEIR EQUITY to acquire another property, instead of the amount of equity remaining after paying applicable Federal and State income taxes on their gain. Additionally, the ability to go from one type of property to another allows an investor to utilize other concepts such as; leverage, diversification, cash flow, consolidation, management relief, and possibly increase their depreciation.
It is possible under the current IRS Section 1031 rules to continue to exchange properties, using all of your equity, thus potentially increasing the net worth of your portfolio much faster than if you were to sell properties, pay the taxes, and then acquire another property with the remaining equity.
When is a 1031 Tax-Deferred Exchange applicable?
It is applicable when the property in question falls within the "like-kind" definition and the principal intends to BUY another property of "like-kind" within 180 calendar days following the close of escrow from the SALE, and when the investor has a recognizable gain.
CAUTION must be exercised in this area. Property does not have to appreciate in value to have a gain! The property may have a "built-in" gain as a result of a previous exchange or from depreciation taken. Be sure to consult with your legal and/or tax advisor.
Remember, under the delayed exchange parameters, there is a maximum of 180 calendar days to purchase replacement property. Therefore, if the principal is not sure at the time of closing the sale property, it is imperative that the transaction be structured as an exchange rather than a sale. Otherwise, if escrow has closed without the exchange in place, the principal will have receipt of proceeds and cannot perform an exchange.
The worst-case scenario is that if the exchange is "set up" and the principal decides not to buy replacement property and takes the proceeds, the principal just pays taxes as s/he normally would. Without the exchange being "set up", the principal does not have that option. An informed client/seller will appreciate the flexibility.
What is the current identification period and closing time to accomplish a delayed 1031 Tax-deferred Exchange?
After an exchange has been arranged by contacting a Qualified Intermediary prior to closing a sale, the seller/exchanger must identify up to three (3) potential properties they MAY intend to acquire, within 45 days of the close of the "sale" escrow. It is immaterial what the value is of the potential properties.
One can list or identify four (4) or more properties however, these properties cannot have an aggregate value of 200% or more of the sale property. If more than three (3) properties are identified, and the value exceeds 200% of the sale price, then you must close escrow on 95% of the list. Escrow must close, on at least one of the identified properties, within 180 calendar days from the date of the close of the sale escrow. Be sure to check with your legal and/or tax advisor.
What happens to the money?
In the first Phase of the Exchange, it is imperative that the seller/exchanger (who is the owner of the property) does NOT receive any money. The seller's net proceeds are wired to the intermediary into a separate, interest-bearing account. Each exchange has its own account, therefore, you must call the Intermediary BEFORE wiring to obtain the account number. If not, the wire will probably be returned to you due to insufficient information.
In the second Phase of the Exchange, the funds required to close the transaction will be sent to you from the exchange account held by the Intermediary. You will need to contact the Intermediary to find out exactly how much money is in the exchange account. In the event there are insufficient funds in the exchange account to close your escrow, then the exchanger will have to deposit the additional funds required to close the escrow.
What is a qualified intermediary?
Paramount to any exchange is a competent Qualified Intermediary (may also be known as the Accommodator or the Facilitator). The Intermediary is the entity which structures, consults, guides and documents the exchange transaction from beginning to end. A sound Intermediary will provide safety and security for the funds held and provide the technical experience needed to maintain the integrity of the exchange. They do not replace competent tax or legal advice. Quite the contrary, they are not allowed to give tax or legal advice, as this could disqualify them as an Intermediary.
Do I need a qualified intermediary?
In the regulations of 1991, many of the "grey areas" were clarified in Section 1031 of the Internal Revenue Code, and established the Safe Harbor provisions.
Safe Harbors include:
1) The use of a Qualified Intermediary;
2) Receipt of interest or "growth factor" by the exchanger;
3) The use of a qualified escrow account; and
4) The use of security instruments in an exchange (such as the use of a Qualified Intermediary; qualified escrow/closing and trust accounts; third party guaranty).
What is needed when the exchanger is a partnership, corporation, or trust?
There is nothing different in how the exchange is handled, but the Intermediary will need to see a copy of the Trust Agreement, the Partnership Agreement, or a Corporate Resolution.
How should the exchanger's name be vested in the deed?
To have a valid exchange, the exchanger's vesting should be exactly the same in the second Phase transaction as it is in the first Phase. Therefore, if the exchanger owns the relinquished property in his/her personal names, the exchanger should not try and put the replacement property into a family trust until after the exchange is closed.
Is a 1031 exchange always 100% tax deferred?
No. For an exchange to be 100% tax deferred, the exchanger must acquire a replacement property that is of equal or greater value and spend all of the net proceeds from the relinquished property.
What is boot?
Boot is defined as any non "like-kind" property received by the exchanger in the exchange and it is taxable.
1) Cash Boot: Cash Boot consists of any funds received by the exchanger, either actually or constructively. If an exchanger does not spend all of the proceeds from the sale of the relinquished property, he/she will have actual receipt of the balance not spent and pay taxes on that amount.
Constructive receipt of funds may occur in a case where the exchanger carries back a note from his/her buyer of the relinquished property, and then sells that note at a discount. The exchanger never actually receives funds for the discounted amount, however, he/she has constructively received that discount and pays tax on that amount.
2) Mortgage Boot or Debt Relief: Mortgage Boot occurs when the exchanger does not acquire debt that is equal to or greater than the debt that was paid off; therefore, they were "relieved" of debt. If the exchanger does not acquire equal or greater debt on the replacement property, they are considered to be "relieved of debt", which is perceived as taking a monetary benefit out of the exchange. Therefore, the debt relief portion is taxable, unless offset by adding equivalent cash to the transaction. More to it than just spending all the exchange equity!
So, an exchanger must buy a property of equal or greater value while spending the NET (after costs) equity. It is absolutely acceptable to take cash out of the exchange and pay taxes on that amount only.
IMPORTANT: If the exchanger wants cash out of the first Phase of the exchange, the intermediary must be notified immediately. The cash out must come directly out of the closing of Phase I and not from the intermediary. Once the exchange equity is in the "Qualified Escrow Account" at the intermediary's, the exchanger cannot access the funds until the end of the exchange.
What is a 1031 Exchange Boot?
"Boot" can be cash received from the sale of the relinquished property or other non-cash consideration, including any property that is not "like-kind", promissory notes, or debt relief (mortgage boot). If you receive boot in an exchange, it is likely that all or some portion of the boot will be taxed.
If you have questions regarding a 1031 exchange, contact DIS’s comprehensive team of tax
advisors, attorney’s, Real Estate Brokers, registered representatives. Click here for a
complimentary consultation or call 866-261-0104.
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