Cranford & Linder llc
1031 Exchanges
What is a 1031 Tax Deferred Exchange?
A 1031 Tax Deferred Exchange references a code section in the Internal Revenue Code (“IRC”) which if properly structured allows an investor to sell an investment property, and acquire a new property, while potentially deferring all capital gains taxes.
IRC Section 1031 (a) (1) states as follows:
No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is held either for productive use in trade or business or for investment.
A 1031 Tax Deferred Exchange references a code section in the Internal Revenue Code (“IRC”) which if properly structured allows an investor to sell an investment property, and acquire a new property, while potentially deferring all capital gains taxes.
IRC Section 1031 (a) (1) states as follows:
No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is held either for productive use in trade or business or for investment.
What are some reasons to transact a 1031 Tax Deferred Exchange?
There are many reasons property owners or investors seek to transact 1031 tax deferred exchanges, but some of the more prevalent reasons are as follows:
You want to preserve equity by deferring capital gains taxes on appreciated assets. In some cases, you may be able to eliminate capital gains taxes altogether.
You want to increase your income potential by maximizing your return on investment and increasing cash flow from larger properties. This is known as the pyramiding effect.
You want to decrease your level of responsibility for management and maintenance. Your level of involvement would depend on the type of real estate that you purchase. For example, if you purchase a triple net (NNN) lease property, your management and maintenance responsibilities would be minimized.
You want to leverage to more profitable investment properties. You can use the deferred capital gains taxes that you would have paid to the government and financing to purchase larger and more profitable investment properties.
You want to diversity your investments. You can sell one property or type of property and buy multiple properties or various types of properties. For example, if you sell a multi-unit residential apartment building, you could potentially buy two triple net (NNN) lease properties.
You want to consolidate your investments. For example, if you sell multiple properties, you could potentially purchase one triple net (NNN) lease property, which may reduce the responsibility for management and maintenance of those multiple properties.
There are many reasons property owners or investors seek to transact 1031 tax deferred exchanges, but some of the more prevalent reasons are as follows:
You want to preserve equity by deferring capital gains taxes on appreciated assets. In some cases, you may be able to eliminate capital gains taxes altogether.
You want to increase your income potential by maximizing your return on investment and increasing cash flow from larger properties. This is known as the pyramiding effect.
You want to decrease your level of responsibility for management and maintenance. Your level of involvement would depend on the type of real estate that you purchase. For example, if you purchase a triple net (NNN) lease property, your management and maintenance responsibilities would be minimized.
You want to leverage to more profitable investment properties. You can use the deferred capital gains taxes that you would have paid to the government and financing to purchase larger and more profitable investment properties.
You want to diversity your investments. You can sell one property or type of property and buy multiple properties or various types of properties. For example, if you sell a multi-unit residential apartment building, you could potentially buy two triple net (NNN) lease properties.
You want to consolidate your investments. For example, if you sell multiple properties, you could potentially purchase one triple net (NNN) lease property, which may reduce the responsibility for management and maintenance of those multiple properties.
What are some of the basic rules governing 1031 Tax Deferred Exchanges?
1. The property must be held or used for the productive use in a trade or business or for investment purposes, which from a real estate investment standpoint may include vacant land, commercial property and residential property Rental Properties including single family homes, condominiums, multifamily properties
Rental Properties including single family homes, condominiums, multifamily properties Commercial Real Estate Farm Land Owner Occupied for Business Tenants in Common Interest for business or investment purposes Vacant or Raw Land Oil and Gas Deeds Typically, your primary and secondary home(s) would not quality for a 1031 exchange unless such properties were converted to a business use or investment use for a specified period of time. For example, your vacation home may qualify for a 1031 exchange if held for rental purposes before and after the exchange for a specified period of time.
1. The property must be held or used for the productive use in a trade or business or for investment purposes, which from a real estate investment standpoint may include vacant land, commercial property and residential property Rental Properties including single family homes, condominiums, multifamily properties
Rental Properties including single family homes, condominiums, multifamily properties Commercial Real Estate Farm Land Owner Occupied for Business Tenants in Common Interest for business or investment purposes Vacant or Raw Land Oil and Gas Deeds Typically, your primary and secondary home(s) would not quality for a 1031 exchange unless such properties were converted to a business use or investment use for a specified period of time. For example, your vacation home may qualify for a 1031 exchange if held for rental purposes before and after the exchange for a specified period of time.
2. In order to defer all of the capital gains tax, the Net Selling Price (NSP) of the property being purchased must be equal to or greater than the NSP of the relinguished property (NSP = Contract Price -Title Fees/Real Estate Commissions).
3. Timing Rules
a. Within 180 days of the closing on the sale of the relinguished property, the exchanger or investor must close on all intended purchases; and
b. Within the first 45 days of the 180 day period, the exchanger or investor must identify up to three (3) possible replacement properties. Only those properties identified as of the 45th day will qualify for the exchange. Please note, that other rules and restrictions apply to investors who wish to identify more than three (3) properties.
a. Within 180 days of the closing on the sale of the relinguished property, the exchanger or investor must close on all intended purchases; and
b. Within the first 45 days of the 180 day period, the exchanger or investor must identify up to three (3) possible replacement properties. Only those properties identified as of the 45th day will qualify for the exchange. Please note, that other rules and restrictions apply to investors who wish to identify more than three (3) properties.
4. Use of a Qualified Intermediary (also known as the “QI”), a QI is a company that facilitates the exchange through an assignment of the contract, the holding in escrow of the sales proceeds from the sale of the relinguished property or properties and then the disbursement of the sales proceeds upon closing of title for the replacement property or properties. The QI cannot be an agent or fiduciary of the investor (for example, the QI cannot be the investor’s attorney, CPA or realtor).
Frequently Asked Questions:
If I will have to pay the capital gains taxes sooner or later, what is the point of transacting a 1031 tax deferred exchange? Through careful planning, you may be able to avoid ever having to pay the taxes.
Is it true that I will have to buy something that costs more than I am selling? No. You can purchase a property that costs less than the relinguished property, but that means that you would not be able to defer ALL of your capital gains tax.
Is it true that I will have to swap properties with the same person? No. You can sell your property to someone who is completely unrelated to your purchase.
Is it true that I can only exchange into the same type of property? No. Most, if not all real estate qualifies for 1031 exchange treatment, which means for example, you can sell a vacant parcel of land and then purchase a multi-unit residential apartment building.
After I transact a 1031 tax deferred exchange, can I sell the replacement property in the future and transact another 1031 tax deferred exchange? Yes. Real estate investors often transact multiple 1031 tax deferred exchanges over many years in order to purchase larger more profitable real estate investments, but such transactions must satisfy the tax laws in order to receive 1031 exchange treatment.
If I will have to pay the capital gains taxes sooner or later, what is the point of transacting a 1031 tax deferred exchange? Through careful planning, you may be able to avoid ever having to pay the taxes.
Is it true that I will have to buy something that costs more than I am selling? No. You can purchase a property that costs less than the relinguished property, but that means that you would not be able to defer ALL of your capital gains tax.
Is it true that I will have to swap properties with the same person? No. You can sell your property to someone who is completely unrelated to your purchase.
Is it true that I can only exchange into the same type of property? No. Most, if not all real estate qualifies for 1031 exchange treatment, which means for example, you can sell a vacant parcel of land and then purchase a multi-unit residential apartment building.
After I transact a 1031 tax deferred exchange, can I sell the replacement property in the future and transact another 1031 tax deferred exchange? Yes. Real estate investors often transact multiple 1031 tax deferred exchanges over many years in order to purchase larger more profitable real estate investments, but such transactions must satisfy the tax laws in order to receive 1031 exchange treatment.