With real estate values approaching all-time highs, the I.R.S. Section 1031 like-kind exchange marketplace is seeing record-breaking transaction numbers. That’s because, in a nutshell, a 1031 exchange is a powerful tax-deferment strategy used by some of the most financially successful real estate investors. If you have seen significant appreciation in your investment or business property, want to continue generating a good return on your hard earned investment and are adverse to paying taxes, it’s important to understand why you should consider a 1031 exchange.
What is a 1031 exchange and why should you use one?
If you sell an investment or business property, you can get hit with a large tax bill, especially if you sell it for a large profit or have owned it for a long time. These taxes can be upwards of 15 percent to 20 percent for long-term capital gains, depending on your tax bracket. For depreciation recapture, it can be 25 percent just at the federal level, with additional state taxes due based on your state tax laws. However, a 1031 exchange allows you to use the proceeds from that investment property to buy another property of equal or greater value to defer your tax liability in the process.
If you’ve seen capital appreciation on your investment, a 1031 exchange could lead to substantial savings when the proceeds from the sale are reinvested in a new property of equal or greater value. By having more investable proceeds, you can purchase a larger property and could earn substantially more income based on the type of investment you acquire. If you only want to reinvest some of the proceeds, you can take some cash out and pay the taxes due on the cash-out portion and reinvest the balance of the proceeds, deferring any tax liability on the reinvested proceeds.
A 1031 exchange isn’t just about saving on taxes. A major benefit is the ability it gives investors to shift the focus of their investing. For example, if you’re currently investing in a residential property that takes up too much of your time and are looking to switch to a less time-consuming property or if you’re simply looking to relocate your investment to a different real estate market where pricing is more attractive, a 1031 exchange can facilitate that as well.
What are some misconceptions about 1031 exchanges?
One misconception is that you can only exchange “like-kind” properties. While that is true, people often misunderstand the definition of like-kind properties. Nearly all real estate is considered like-kind. For example, all residential, retail, office, industrial/warehouse, or self-storage properties can be exchanged for one another.
One thing to keep in mind about 1031 exchanges is that you can also exchange one property for multiple properties, and vice versa. Often people believe that a 1031 exchange is one for one, but you can either exchange multiple properties into one larger property or one large property into multiple smaller properties and defer your tax liability, as long as the properties acquired are collectively of equal or greater value than the property sold.
Another popular misconception is that the 1031 exchange has to happen simultaneously where the sale of a property occurs at the same time as the purchase of the replacement property. Although this can occur, the vast majority of 1031 exchanges are delayed exchanges so there are time buffers built-in to the process. Sellers have 45 days following the close of the sale of their property to identify up to three replacement properties. The purchase of at least one of the replacement properties must occur within 180 days of the original sale. This includes the conveyance of title to all of the replacement properties being acquired. Again, as long as the replacement property is of equal or greater value the taxes may be deferred.
If executed properly, a 1031 exchange can be a smart move for real estate investors. It can also be a complex process, that involves many legal requirements that must be followed utilizing qualified intermediaries, tax and legal advisors as well as access to suitable potential replacement properties that will involve careful due diligence, underwriting, financing, and timely closing.
At Senné, we have the team to facilitate all aspects of a 1031 exchange. Our clients and investors can count on our Certified Public Accountants and acquisitions managers to properly utilize the IRS tax code to increase the return on their investment and build more future wealth. If you are considering the sale of one of your investment properties and would like to reinvest the proceeds without the burden of significant taxes, give us a call to see how we may assist you in the process.