Real estate has always been regarded as one of the top choices for investors especially here in the United States. Smart investors look at real estate as a reliable way to accrue revenue and build generational wealth. Success in real estate can vary greatly depending on asset types, risk appetite, management skills, holding period or exit strategies. When buying or, selling a property, working with qualified industry professionals allows investors to mitigate risks, alleviate stress and leverage financial tools that, if utilized properly can help maximize their Return on Investment. 1031 exchange is one of those strategic tools that help investors grow or enhance their portfolios.
What Is A 1031 Exchange?
Earning its name from Section 1031 of the United States Internal Revenue Service (IRS) code, a 1031 exchange is a tax code that makes it possible for investors to defer the payment of federal capital gains taxes by swapping one sold investment property or one that’s used for business purposes for another property within a certain time frame after closing on the sale of the initial asset. Being able to properly execute a 1031 exchange may help a real estate investor save money while gaining more buying power toward a like-kind property or properties.
That all sounds great and exciting however it is paramount that all legal guidelines and regulations are followed for a 1031 exchange to be valid. Below are few rules to pay close attention to when attempting to execute a 1031 exchange. Keep in mind that these are not all the rules, and a tax advisor or legal counsel should be consulted before making a major financial decision
Steps to follow for a successful 1031 exchange
Identify the replacement investment property
The properties that are being exchanged must be considered like-kind by the IRS in order for them to qualify for a 1031 exchange. The like-kindness generally meaning real estate for real estate. The targeted replacement property or set of properties must be of equal or greater combined value to the relinquished property in order to be fully deferred. Partial exchange are allowed according to federal tax laws.
Be mindful of 1031 Exchange Timeline & Rules
of 1031 Exchange Timelines & Rules
- 45 Days Rule -Beginning from the day following the closing date of the relinquished property, an investor has 45 days to identify a replacement property.
- 180 Days Rule – Using the same closing date as point of reference, the exchange must be completely finalized withing 180 days of the sales of the relinquished property. This timeline must be scrupulously followed with no exception unless the exchange is affected by a federally declared disaster.
- 3 Properties Rule -Finding the right property for a 1 to 1 exchange within the 180 days period of eligibility can be challenging or impossible in some markets. the three property rule allows an investor to target up to three properties for reinvestment.
- 200% Rule – The 200% rule allows the investor to identify unlimited replacement properties as long as their cumulative value doesn’t exceed 200% of the value of the original property sold.
- 95% Rule – According to the 95% rule, an investor is allowed to identify as many properties as desired as long as the acquired properties are valued at least 95% of the total value of the relinquished asset.
Hire a qualified intermediary to assist you
Choosing a qualified intermediary to facilitate the process is a vital step in properly executing a 1031 exchange. In order to maintain the legality of the exchange, the proceeds received from the sale of the relinquished property must, prior to closing be transferred to a qualified intermediary, rather than wired to the seller. It is important to follow the rules governing the transfer and the handling of funds to avoid potential legal pitfalls.
Report the details of the transaction to the IRS
For the 1031 exchange to be finalized, the real estate investor must report the transaction on their tax return. The IRS form 8824 provides a section where a description of the relinquished property and its replacement(s) can be laid out in detail. In addition, the timeline of each transaction, the parties involved in the exchange, and the funds must be outlined in a comprehensive manner. Consult with tax advisor or legal consul.
Practical Benefits of a 1031 Exchange
There are several benefits to leveraging a 1031 exchange when upgrading or diversifying your real estate investment portfolio. Here are a few practical benefits of a properly executed 1031 exchange.
- Deferring capital gains tax which will free up more capital to be invested in a replacement property.
- Diversifying or consolidating a real estate investment portfolio could potentially yield better cash flow opportunities.
- 1031 exchange allow investors to stay agile and adjust to changing market trends by acquiring assets with better ROI appeal.
In conclusion – A 1031 exchange is one of the smartest ways for savvy investors to stay ahead of the game when building or managing a real estate investment portfolio. Because of its legal technicalities, a qualified intermediary must be involved from the earliest stages of the transaction. When executed properly, a 1031 exchange has the potential to save you money, give you more buying power and most of all improve the overall cash flow performance of your real estate portfolio.