Text by Toija Beutler, Attorney/Owner, Beutler Exchange Group, LLC
1031 is an incentive program for the Investor who owns rental properties, commercial properties or investment land. When the Investor sells they can defer the payment of the capital gains tax … as long as they work with their real estate agent to find and buy a replacement property and comply with the 1031 rules.
1031 builds wealth
Because the Investor doesn’t have to pay tax on the gain, more cash is available for the purchase of the next bigger and better property.
The definition of “like kind” is the best feature of 1031. All real estate is like kind with all other real estate as long as what is being sold and bought is rental, commercial or land held for investment.
Example: The Investor can sell investment land (non-income producing) and buy a residential rental (income producing).
Example: The Investor can sell a residential rental and buy a commercial property.
Very popular example: The Investor can sell a residential rental and buy a residential rental that will become either a second home or a primary residence — after 24 months of seasoning as a rental.
This frees up the investor to purchase a property that better suits their personal or business goals. And, because 1031 is federal law, the Investor can sell in one state and purchase in a different state — thereby “moving” their investments around the country.
Yes, there are rules, many of which will be surprising to the Investor.
The Investor must close on the new property within 180 days of closing the sale of the old property. The worst feature of 1031 is that they only have the first 45 days of the 180 to identify the replacement property. Most Investors can only list three properties and they must buy from the list. 45 days is an exceedingly short time in which to find suitable property, especially with the current limited inventories.
1031 is not for second homes, flips, new construction or land held by a builder or developer. These are personal use properties or inventory properties and not eligible for the tax deferral.
To get the best result the Investor will apply the net cash from the sale toward the purchase of the new property and obtain a new loan that equals or exceeds the loan on the old property. This makes sense when you consider that the Investor, owning and selling a rental house, has $300,000 in the American economy. If they sell and pull that investment out of the American economy, they have to pay tax on the gain. If they don’t want to pay tax on the gain they have to drive $300,000 back into the American economy, whether using their own cash and/or financing.
The exchange company prepares specialized documents for the Investor to sign in closing as they sign the deed to the Buyer. There will be similar documents at the closing of the new property. It is the exchange company’s paperwork in those closings that creates the exchange and tax deferral. The following spring the accountant reports the exchange on the tax return.
Consultation with the Investor’s accountant will confirm whether an exchange will benefit the Investor.
Consultation with an exchange company, sooner rather than later, is essential to understanding the rules and common pitfalls. Exchange companies do not charge for this consultation. Their fees are typically flat rate and charged at the time of closings.
Consultation with the Investor’s real estate agent is critical to understanding the market and options that will be available before and during the 45-day identification period.
Challenging scenarios that particularly require consultation:
- Wanting to buy from a related party.
- Breaking up or forming partnerships at the time of an exchange.
- Making improvements as part of the exchange.
- Closing on a new property before closing the sale of the old — a reverse exchange.
- An installment sale of the old property.
The best exchanges not only shelter tax but also achieve important business and personal goals.
The original article can be found HERE at All Things Real Estate Magazine’s website.