Section 1031 exchange investments: How does it work?

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Tax deferrals are one of the most effective tools in asset management. By postponing the payment of your tax, you allow your investment to generate more income. Your portfolio longevity also extends as tax-advantaged assets are usually availed in higher amounts, and higher amounts result in higher gains that exceed your estimated income and investment years.

To be specific for real estate investing, there exists an IRS code which is the 1031 Like-kind exchanges. In the event where you want to exit a holding and exchanging property, it is most definitely possible for capital appreciation. As the demand for land, structures, spaces, and other real properties grows through time, when you replace your asset, it will be of higher value from the original purchase price. The difference between the price of the asset back then and its appreciated value now becomes your capital gain. However, when you do not avail of the 1031 exchange investment, your earnings from the transaction will be immediately deducted of its tax implications. Whereas when you utilize 1031 exchange investments, you are deferring taxes for capital gains and depreciation recapture. Here’s how it works:

1031 exchange investments allow you to find a like-kind replacement property that is similar in nature and in value to what you have just sold. Your gains from the transaction of exchange will be considered as capital to your new like-kind exchange investment, so it is not truly deemed as a gain at the moment. In 1031 exchange, it is truly a cycle of passing earnings from one investment to the other, and in each investment, your proceeds increase every time which becomes a driver for income generation.

Although the definition and purpose of section 1031 exchange investments are straightforward and can be easily grasped, applying, and qualifying for it is what people will find as a challenge.

What are the guidelines in qualifying for a 1031 tax deferral?

  • Properties being exchanged must be used for investment, rental, and commercial purposes
  • Only like-kind exchanges are accepted in the application for 1031
  • Instead of selling, investors must be exchanging the properties

What are the steps in applying for a 1031 exchange investment?

  • Within 45 days, you must identify a potential replacement property. 

You can present up to three properties. If you wish to identify more, there is a 200% rule where the aggregate value of the properties you have chosen should not exceed 200% of the original property. Additionally, a 95% rule governs the case where you can identify multiple properties given that the total fair market value of these properties is equivalent to 95% and are already exchanged by the end of the given period. 

  • Hire a reputable and qualified intermediary to handle the legal and financial requirements of 1031. Your broker or lawyer must be truly trust-worthy as the money from the exchange can only be held by an intermediary
  • Close the transaction by exchanging your relinquished property.
  • Make sure to acquire the approved replacement property within the 180-day period.

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