Why Consider a 1031 Exchange?
There are many advantages to structuring your transaction as a 1031 Exchange. Below are some key reasons why you should consider this option:
Benefits of a 1031 Exchange
- Defer Taxes: Defer up to 35-40% of the capital gains on your sale.
- Greater Purchasing Power: By deferring taxes, you have more capital to reinvest.
- Improve Cash Flow: Reinvesting can enhance your cash flow through better assets.
- Diversify or Consolidate a Real Estate Portfolio: Adjust your portfolio to meet your financial goals.
- Build & Preserve Wealth: Utilize the exchange to grow and safeguard your wealth.
- Greater Appreciation Potential: Invest in properties with higher appreciation potential.
- Switch Property Types: Move from one type of investment property to another.
- Expand into New Real Estate Markets: Enter different geographical real estate markets nationally.
- Estate Planning: Provide benefits to heirs through tax deferral.
Requirements for a 1031 Exchange
To defer capital gains taxes on long-term investment properties (personal primary residences, short-term holds, and flipped properties do not qualify), the following conditions must be met:
- Replacement Property of Equal or Greater Value:
- Must purchase a property of equal or greater value (after deducting real estate commission, escrow fees, title policy fees, and recording fees).
- Debt of Equal or Greater Amount:
- If there was debt on the relinquished property, the replacement must carry equal or greater debt, or cash must be injected to meet this requirement.
- If there is no debt on the relinquished property, this requirement is satisfied.
- Roll All Equity and Proceeds:
- All proceeds from the sale must be invested into the replacement property.
Taxable Consequences
The Exchanger will face a taxable event if:
- The replacement property is of lesser value.
- Debt relief is not offset by new debt.
- The Exchanger receives “boot” (i.e. cash, non-like-kind property).
Fees for 1031 Exchange
- Exchange Fee: For one relinquished property under $3 million and one replacement property, the flat fee is $950.
- Additional Properties: Each additional property in the same exchange incurs a flat fee of $250.
Note: These fees are as of 2018 and may vary depending on your specific transaction.
Delayed Exchange Structure
- 45-Day Identification Period: You have 45 days from the sale of the relinquished property to identify a replacement property.
- 180-Day Purchase Period: You must close on one of the identified properties within 180 days.
Documentation Required for a 1031 Exchange
- Contact information for the escrow/closing officer.
- A copy of the fully signed contract.
- A copy of the title commitment/abstract report.
- Entity formation documents, if applicable (LLCs, partnerships, corporations).
- Cell number and email address for each seller/exchanger (for DocuSign).
FIRPTA (Foreign Investment in Real Property Tax Act)
If you are a foreign person, consult with a tax advisor to determine whether FIRPTA applies to your transaction.
Related Party Considerations
- Related parties, as defined in IRC §267(b) and §707(b)(1), include family members, entities under common ownership, and partnerships.
- Exchanges with related parties may be disqualified if the related party cashes out while the Exchanger defers taxes. Exceptions exist when both the Exchanger and related party are conducting exchanges.
Closing Costs on Replacement Property
Be aware that loan fees paid with exchange funds may create taxable “boot,” as these fees are considered loan costs rather than property acquisition costs.
Conclusion
A 1031 Exchange is a valuable tool for investors to defer taxes and grow their wealth. However, it involves specific requirements and conditions. Consult your tax advisor for advice tailored to your situation.
For more information, visit IPX1031, a trusted resource for 1031 exchanges that has helped many of our clients successfully navigate this process.