A 1031 exchange, also known as a like-kind or Starker exchange, can be a beneficial way to defer taxes on a real estate investment, if used properly. Here, the real estate and mortgage professionals at Powerhouse Title Group explain the details of a 1031 exchange.
Defining 1031 Exchanges
According to IRS tax code, section 1031, it is possible to defer capital gains tax upon the sale of an investment property, if the profits from the sale go directly to purchasing a “like-kind” property. Because it is unlikely that someone who wishes to purchase your property will own a property you wish to purchase in turn, most 1031 exchanges are delayed, in which a broker holds onto the profits from the sale of your property, and then purchases a property for you—to the IRS, this is still a legal “swap” under 1031 law.
What Does “Like-Kind” Mean?
Prior to 1984, 1031 exchanges had to be exact exchanges—if, for example, you were selling a plot of land with a barn, you must in turn be purchasing a plot of land with a barn. Now, the like-kind concept is far broader. Assets must be “similar in like or nature, even if they differ in grade or quality.” So, for example, you could exchange a commercial building for a single-family rental, but could not trade commercial restaurant equipment for a duplex.
To avoid capital gains taxes at the time of sale, the property you purchase must have equity and a net market value greater than or equal-to the property sold. If not, the cash profits will be taxed. This may be fine for those who wish to make some cash and are unconcerned by some tax. An option for avoiding this, however, is to purchase multiple properties that have a combined value greater than or equal-to the sold property—you can purchase as many properties as necessary.
Benefits of a 1031 Exchange
Aside from deferring capital gains taxes, a 1031 exchange can be beneficial to those who have made poor investments and seek to secure better ones, or for those who have made great investments and wish to continue growing their portfolio. There is no limit to the number of 1031 exchanges an investor can execute. So, theoretically, an investor could continue capitalizing on 1031 exchanges until their passing, continuously growing their wealth without taxation. This also makes the exchanges a valuable tool for estate planning.
Within 45 days of the closing of their property, a former owner must identify up to three properties of like-kind. The “200% rule” is an exception to this, allowing one to identify four properties, so long as the combined value of the properties does not exceed 200% of the sold property’s value.
The new property or properties must be purchased within six months (180 days) of the closing of the original property. The only deviation from this rule is if the property owner extends his tax return—then the 180 days begins on the date of the extension.
While IRS 1031 exchanges cannot be used on personal property—except sometimes for vacation homes—it can be a valuable tool for investors looking to save money and grow wealth. For additional information on 1031 exchanges, or to speak with an experienced real estate and mortgage professional, contact Powerhouse Title Group today.