1031 Tax Exchange Explained
A 1031 Exchange is a way to defer tax liability on income from the sale of real estate, if you intend to reinvest the income in another real estate purchase within a specified amount of time. The use of the word ‘exchange’ is probably a little confusing, because it’s not a transaction where you trade your property for somebody else’s.
Following the rules and procedures established by the IRS Section 1031 means any gains you make on the sale of the original property are not subject to immediate taxation as capital gains. This is because selling your existing property (known as the “relinquished property”) and acquiring a new property (known as the “replacement property”) is considered an exchange.
Advantages of a 1031 Exchange
1. Deferral of taxes. A 1031 Exchange allows you to sell your investment property and reinvest in a replacement property in order to defer ordinary income, depreciation recapture and/or capital gain taxes. These types of taxes can be quite significant, especially with a low adjusted cost basis, which is why the IRS affords you this invaluable exception in exchanging business or investment property.
2. Leverage and increased cash flow for reinvestment. By deferring taxes, you will have more money currently available for investment. This increased purchasing power gives you the extra leverage to acquire, for example, a property or several properties with significantly higher investment benefits than if you sold the original property, paid all the taxes associated with the sale and purchased a new property.
3. Relief from management. If you own a property or several properties burdened with extensive maintenance costs and requiring intensive management, you may exchange and replace property for others with less responsibility (e.g., newer, on-site management properties or less management intensive property types).
– Miguel Torres
Ensuring a Successful Exchange
In order to capture all the tax benefits of your real estate transaction when engaging in an exchange, you need to follow the proper procedure, which includes:
- Establishing the exchange paperwork and using a Qualified Intermediary (QI) before the sale of your existing property.
- Selling the existing property, or relinquished property—at closing, the proceeds from the sale will be delivered to the QI (not to the property owner) to comply with Section 1031 exchange rules.
- Identifying a replacement property that meets all the requirements of a like-kind exchange. You must do this within a specific timeframe under the existing exchange rules.
- Buying the replacement property within a specific timeframe as outlined in the exchange rules.
- The QI pays the proceeds directly to the replacement property seller to comply with IRS rules, and you receive the deed.
There are other types of exchanges, including reverse exchanges, improvement exchanges, and personal property exchanges. It’s important to work with an experienced QI so the transactions are executed smoothly and you are able to realize all the tax benefits of the transaction.
Capital Gains Tax
If you’re selling your property at a loss, a 1031 exchange would not be the right option for you, since there are no profits to protect; but if you are selling your property for a price greater than when you acquired it, a 1031 exchange can save you the tax you would normally have to pay on the gain. This can add up to substantial savings!
Since reinvesting the income you earn on a real estate sale is good for the economy, the government (See IRS Code on 1031 Exchanges) has allowed this tax saving procedure as an incentive for you to reinvest those proceeds immediately.
– Jason Chen
Depreciation does not apply when you’re selling land. Depreciation is an IRS sanctioned write-off (See IRS Publication on Depreciation), or deduction from your annual income, tied to the total value of your real estate, minus the value of the land under it. It is the government’s way of acknowledging that your building is deteriorating over time through normal wear and tear.
For example: You buy a rental property for $1,000,000 (See IRS Publication on Rental Property Depreciation). It is determined that the land value under the property is $200,000. You can start depreciating the $800,000 building value on your tax return over the next 271⁄2 years.
The Depreciation Calculation
Building Value divided by 27 1⁄2 = Annual depreciation deduction from income. $800,000 ÷ 27 1⁄2 = $29,090/year deduction. You can now deduct $29,090/year from your taxable income. Fast-forward 10 years, and you have deducted a total of $290,909 from your taxable income over this period. Now, if you sell your property for $1,500,000 and you don’t do a 1031 exchange, not only will you pay capital gains tax on the gain, you will also have to pay tax (recapture) on all of the depreciation you have taken over the last 10 years.
In order to have a legitimate exchange, the law requires that an independent third party act as the facilitator. Also called a Qualified Intermediary, the facilitator:
- Prepares the exchange documentsy
- Holds the exchange funds (the proceeds from the sale)y
- Assures compliance to IRS Section 1031 exchange requirementsy
- Coordinates with your real estate agent, title company, tax and legal advisory
- Maintains constant communication and notifies you of all deadlines
- Provides assistance in identifying suitable replacement property
EquityPro Management has extensive experience in closing escrows using an IRS 1031 tax exchange. We have the knowledge, experience and relationships to assist you to implement a 1031 Tax Exchange strategy.