What is a 1031 Tax Exchange? Why Should I do it? And When?
A "1031 Tax Exchange," also known as a Starker Exchange or a Like-Kind Exchange, is a highly powerful tax-deferment tool used by financially successful Real Estate Investors; a tool, which allows folks to keep more of their money, and keep rolling forward, growing and cultivating their investment portfolios.
As we push forward, headfirst into 2019, the 1031 Tax Exchange could possibly be one of the Real Estate Investor's BEST tools in his or her arsenal... WHY? Because many U.S. city's real estate prices have surpassed the "bubble levels" of 11-12 years ago... And real estate is cyclical. Real Experts use a 10-12 year cycle as a general rule of thumb for US real estate market cycles.
So... this is why smart investors are doubling-down that 1st and 2nd quarter 2019 is likely the wisest time to deploy the 1031 Exchange investment strategy.
WHAT IS A 1031 TAX EXCHANGE...Exactly?
They are exchanging properties in expensive markets (like Southern California), for dramatically better ROI in cash-flowing investment properties in less expensive markets (like Nevada, Texas and Middle Tennessee).
The term 1031 Exchange is defined under section 1031 of the IRS Code. In simple terms, it's a strategy allowing an investor to "defer" paying Capital Gains Taxes on an investment property when it is sold - as long as another "like-kind property" is purchased with the profit gained by the sale.
Watch this: There are more than just tax benefits to this strategy too. Employing a 1031 Tax Exchange allows an Investor to change the "type focus" of their investment properties, without incurring the tax liability for this change. For instance; maybe you usually invest in low-income properties - which typically have high maintenance. With a 1031 Tax Exchange, you are allowed to exchange the high-maintenance investment properties, in for low-maintenance properties, without being required to pay thousands of dollars in Capital Gains taxes when you sell. Or, perhaps you want to move your investment portfolio from one location to another without owing the IRS Capital Gains Tax on your property sales. The 1031 Tax Exchange makes this possible.
The most common 1031 Tax Exchange transaction is one where the sale happens first, then the correlating purchase happens some time later. This is called a "delayed exchange" 1031 Tax Exchange. In this case, you need a middleman, or an Exchanger company to hold the cash from your sale, and then use that cash for your replacement purchase when you buy the replacement property(ies).
WHEN DO I DO A 1031 TAX EXCHANGE??
When you go to sell an investment property (a rental), you are on the hook to pay the government Capital Gains Tax... If you’re rental property is worth significantly more now than the price you paid for it, you can pull yourself right out of the lion’s mouth with this strategy. Knowledgeable Investors usually employ this tax tool every time they sell an investment property, unless they do not want to reinvest and / or can offset the Capital Gains Tax by some other tax maneuver (see your Accountant!)
HOW DO I ACTUALLY DO A 1031 TAX EXCHANGE?
First, find a knowledgeable and experienced Real Estate Broker to help you list and sell your target investment property. Next hire an Exchange Company; The Real Estate Broker you hire will likely have companies to refer to you if you do not find one on your own.
The Exchange Company will “hold” your cash upon close of escrow, until you identify your replacement property. Next, find your replacement property(ies)! Make your offer(s) and get into a purchase contract(s). The Exchange Company will wire your sale proceeds cash to the escrow handling the purchase of your replacement property(ies). Close your purchase escrow(s) no later than 180 days from the date you closed your sale escrow.
WHAT IF I DON’T WANT TO REINVEST ALL OF MY SALE PROFIT? I WANT SOME CASH FROM THE SALE..
No problem! You get to avoid the Capital Gains Tax on the portion that your DO reinvest, in compliance with the 1031 Tax Exchange. For the portion of monies that you want to harvest in cash at closing, you will incur some tax consequence. How much exactly, will be determined by your overall tax / income picture.. Make sure you check in with your favorite CPA!
WHEN DO I END UP PAYING THE CAPITAL GAINS TAX?
If an Investor cashes out, meaning sells the property(ies) and keeps the money, then the Capital Gains tax will come into play. But in the meantime, you can and should – trade / exchange properties, and grow value and equity, and avoid an earth-shaking tax bill. The 1031 Tax Exchange is a winning strategy and very valuable instrument for real estate Investors.
WHAT ARE THE RULES?
Both the purchase price, and the new loan amount, must be the same - or higher, on the replacement property. So, if you were selling a rental property for $1 Million in Ventura County that had a $550,000 loan on it, you’d have to buy a replacement property (or more than one property) that had a total price tag of at least $1 Million, and a total mortgage loan(s) of at least a $550,000 on it.
FYI: You can buy more than one replacement property with the profit of a single property sale. For instance, if you sell an investment property for $1Millon, and you want to buy two smaller properties for $500,000 each, you can.
HOW LONG DO I HAVE TO FIND A REPLACEMENT PROPERTY?
In the “delayed exchange,” the most common type of 1031 Tax Exchange, an Investor has a maximum of 45 days to identify the replacement property, and 180 days from the sale closing, to complete the purchase escrow for the replacement property(ies).
For more information about employing the 1031 Tax Exchange for the sale of your investment property, and reinvestment purchase, please give us a call. We'd love to help!