A 1031 Exchange is a real estate investment tool that allows real estate investors to defer capital gains taxes. This can help grow your New Braunfels portfolio and boost your net worth faster and more efficiently. If you have a property manager, as them about how to get involved in 1031 exchanges.
There is a strict process that you must follow in order to get everything right. The following is a basic overview of the Internal Revenue Code (IRC) Section 1031.
Not all real estate properties qualify under the IRC Section 1031. Under the code, the properties being exchanged must be “like-kind.” In other words, they must share the same nature and character, even if the quality may vary.
For instance, it may be possible for you to exchange a vacant land for an apartment complex, or a single-family home for an office building.
Examples of properties that wouldn’t qualify for exchange include bonds, interests, stocks, and securities.
As a New Braunfels Investor, you must follow three important rules for a successful 1031 Exchange. The rules are as follows.
The first rule requires that the replacement property be of equal or greater value than the relinquished property. The second rule requires that the replacement property be identified within a period of 45 days. And lastly, an investor must complete the swap within a period of 180 days.
1. The replacement property must have similar or greater value
As already mentioned, it must have a value similar or greater to the property you’re replacing it with. You can do this in either of three ways.
- Identify up to 3 properties irrespective of their fair market value
- Identify an unlimited number of properties if their combined fair market value doesn’t surpass 200% of the value of the relinquished property
- Identify an unlimited number of properties so long as the properties you acquire are valued at at least 95% of the property you’re relinquishing
What is a replacement and relinquished property in a 1031 Exchange? A replacement property is the “like-kind” property that you aim to replace your current property with. A relinquished property, on the other hand, is the property that you aim to sell or dispose of in a tax-deferred exchange.
2. The identification of the replacement property must be done within 45 days
When doing a 1031 exchange, it’s important that you plan ahead. That’s because the IRS only gives investors a maximum of 45 days to identify the property they aim to replace their current property with.
This period, as all other periods in a 1031 Exchange, aren’t optional. What’s more, no extensions or exceptions exist. And the period includes both weekends and holidays.
3. The exchange must be completed within 180 days
The exchange must occur not later than 180 days after you have sold the relinquished property.
Also, please note that it’s only a Qualified Intermediary (QI) that can facilitate the exchange process. You cannot be the QI, neither can any person that works for you or have a personal relationship with.
A QI can only be an independent person, a company, or an entity that enters into an agreement to facilitate and coordinate the transfer proceeds.
Usually, a qualified intermediary is a lawyer, an accountant, or a real estate agent.
What is “Boot”?
If you fail to follow the process correctly, “boot” may arise. The term “boot” refers to non-like-kind property that an investor receives during a 1031 Exchange. In other words, it’s the portion of the sales proceeds that isn’t re-invested in a replacement property.
For example, suppose you sell a property for $100,000. However, instead of re-investing the entire $100,000 into buying the replacement property, you only re-invest $80,000. In such a case, the difference of $20,000 would be boot.
Remember, the primary goal of conducting a 1031 Exchange is to avoid paying capital gains tax. However, by receiving boot, it means that exact opposite has occurred as boot is taxable. So, from our previous example, the $20,000 would be subject to capital gains tax.
Boot can occur from a variety of factors. The following are the most common ones.
- Cash proceeds
- Mortgage reduction
- Personal property
- Non-like-kind property
- Non-transactional costs
The following are a few things you may to do in order to avoid creating boot in a 1031 Exchange.
- Trade up in real estate value. In other words, make sure that the replacement property is either of the same or greater value than that of the relinquished property.
- Reinvest all the proceeds you get from selling the relinquished property into buying the replacement property
- Bring with you some cash to closing in order to pay for any items that may not qualify as like-kind. Such items may include tenant deposits, rent prorations, or outstanding vendor invoices.
Types of 1031 Exchanges
There are four types of 1031 Exchanges that are commonly used by real estate investors.
- Delayed Exchange. This is a type of a 1031 Exchange where the exchange occurs through the use of a Qualified Intermediary (QI). It’s common and straightforward: the exchanger relinquishes a property prior to acquiring a replacement one.
- Simultaneous Exchange. This is where closing of the relinquished property and the replacement property is done at the same time. Unlike in a Delayed Exchange, there is no interval between the two closings.
- Reverse Exchange. This is the opposite of a Delayed Exchange. Here, the exchange occurs when a taxpayer acquires the replacement property prior to transferring the property they are relinquishing.
- Build-to-suit Exchange. This is also referred to as a construction or improvement exchange. It allows a taxpayer to build, construct, or make capital improvements to a property prior to acquiring it as a replacement.
1031 Exchanges are a valuable tool for investors. When used properly, it can allow an investor to defer payment of capital gains taxes for a long time to come. And over time, your profits from 1031 Exchanges can compound to greater and greater earnings.
For expert help in this regard, Limestone Country Properties can help. Get in touch with our team to learn more!