1031 Exchanges allow you to defer the gain on the sale of a business use or investment asset as long as you acquire another business use or investment asset. This includes office buildings, rental real estate, business equipment, franchise equipment and even aircraft.
More importantly, they allow you to use the money you would have paid in both federal and state capital gains taxes to improve the quality, value, and sometimes, location of their holdings and better plan their financial future. The long term windfall amounts to an interest free loan from Uncle Sam to leverage larger investments, diversify your portfolios, and substantially increase wealth.
1031 Exchanges allow you to get an interest free loan from the government and avoid paying capital gains tax at the time of the exchange and to preserve your investment capital by deferring rather than paying the capital gains.
There are three replacement property rules:
1. 3 properties: you can identify up to three properties without regard to value, or:
2. 200%: you can identify more than three provided the replacement properties do not exceed 200% of the vallue of the relinquished properties, or:
3. 95%: you can identify any number of properties regardless of value provided the exchanger purchasers 95% of the identified properties. This is the most perilous and rarely used rule, nerve wracking for the investor who should have a back up plan in case the 95% isn’t realized.
You’ve got to exchange for equal or greater value property.
The first step is to find a good QI, a qualified intermediary to set up the exchange. Choose a reputable firm with experience.
If the projected capital gains tax exceeds $20,000, it’s likely a 1031 is worthwhile. Going even or up in value will avoid taxable boot but that doesn’t preclude cashing out on some small portion which would then be taxable.
There are two key timelines to complete a 1031, and most importantly, you have to set up your 1031 before closing on the property you’ll exchange.
You have 45 days to identify up to three replacement properties from the time you close on your relinquished property and no substitutions are permitted after the 45th day, or identify an unlimited number of replacement properties as long as they don’t surpass 200% of the value of the relinquished property or properties.
Second, you have to close on the replacement property within 180 days of your closing, not from the day that property goes under contract. These two deadlines are non-negotiable. If you can’t perform within these time frames, the 1031 is dead and the taxes become due. Presidentially declared disasters are the only allowable extension.
Once the 1031 is set up, you close on your original property by selling first to the QI who then sells immediately to the buyer. The proceeds of the sale are then held by the QI who acts as our trusted holder until you close on your replacement properties. You are not permitted constructive receipt of any of the funds and can’t touch any of these funds until you close on the replacement property or it becomes boot and is instantly taxable.
Like kind exchanges, required by 1031 exchanges, are commonly misunderstood. Like kind includes any other real estate. A single family can be exchanged for an apartment complex, a condo, an office building or even raw land or a shopping center.
A duplex does not need to be exchanged for a duplex; you could purchase a 25 unit rental complex. An airplane is business equipment can’t be exchanged for a 25 unit rental property. It matters not what kind of real estate, rather how that real estate is used. It must be for business, commercial or investment use and owned for at least a year.
Convert investment property into personal property by exchanging for a private residence and renting it out of the gate and moving in after the first two years of ownership. Be aware though that the first two years of business use will be fractionally deducted from the residential use years in calculating the section 121 $250k/$500k personal residence exclusion at the time of sale. If owned for 10 years, two of which were as a rental, just 80 per cent of the personal residence exclusion would apply at the time of sale. You’ll need to live in it for at least a year and own it for at least five years.
Certain kinds of personal property can be exchanged for other personal property too as long as they fall into the same asset class or product code. Reverse exchanges occur when the exchanger purchases the replacement property first, placing it in an SPE (Single Purpose Entity, renamed by the IRS as an EAT, Exchange Accommodation Title Holder) and then closes on the relinquished property before taking title to the replacement property.
You can also relinquish an investment property for a raw piece of land of lesser value and improve it during the 180 day period, then conclude the 1031 on the then improved more valuable piece of property.
Can you buy first and then sell?
Yes, but this is a riskier 1031 known as a reverse exchange. Riskier as you have to find the buyer and close within 180 days, a potentially much murkier endeavor than buying in six months.
Swap till you drop. Continue swapping until your gone. Step up in basis, at the time of your death: your children or inheritance recipients can sell the property for what it’s worth at the time of your death, and not be taxed on a gain calculated based on what you originally paid for the asset.
Contact a 1031 QI (Qualified Intermediary): Edmund & Wheeler at 603.444.0020, email@example.com
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