Selling investment property can bring a hefty tax bill. But what if you could defer those taxes while reinvesting in similar property? This is where the IRS Code 1031 exchange comes in. Investors, did you know you can trade in one property for another of equal value and get a free pass on paying capital gains taxes, depreciation recapture, and net investment income tax?
For the past 23 years, I’ve guided real estate investors through 1031 exchanges. From choosing a Qualified Intermediary to identifying and closing on replacement property, I’ve seen firsthand how this strategy helps grow portfolios. My focus is on Triple Net Lease, Fractional Ownership, and Institutional Quality properties—though all real estate asset classes are possible.
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Understanding IRS Code 1031 Exchange Rules
The Internal Revenue Code 1031 exchange, often called a like-kind exchange, lets you defer taxes on profits from selling relinquished real property if you reinvest the proceeds into similar property. This is not a loophole but a specific part of the tax code meant to promote investment and economic growth.
There are specific rules to follow for 1031 like-kind exchanges. Having a qualified guide on your side can be a lifesaver when dealing with such intricate regulations. There is timing around when you can reinvest after you sell a property and specific closing details to follow.
Like-Kind Property
The “like-kind” aspect is important. While this once included a broader range of assets, after the 2017 Tax Cuts and Jobs Act, it now only covers real property held for investment or productive use in a trade or business.
Exchanging an apartment building for another apartment building is acceptable. But “like-kind” simply means replacing investment property with investment property. The real estate asset type or class really doesn’t matter.
However, exchanging a U.S. property for one overseas is no longer allowed. Real properties within the United States are generally considered like-kind, whether improved or unimproved.
The 45/180-Day Rule
Timing is critical in a 1031 tax deferred exchange transaction. Once you sell relinquished property, you have 45 days to identify up to three potential replacement properties.
You must close on one of these identified properties within 180 days or by the due date of your tax return (with extensions), whichever comes first. Blow past those deadlines and you might find yourself staring down a hefty tax bill.
“Boot” and Partial Deferral
Sometimes, the fair market value of the exchanged property differs. The person receiving the lower-value property might receive cash to “equalize” the transaction. This cash is called “boot.”
While the exchange transaction aims to defer taxes, receiving boot can trigger some tax liability. You’ll be taxed on the boot’s value. Ideally, 1031 exchanges work best when both assets have comparable values.
If you sell property and reinvest the cash elsewhere, this gain or profit will also count towards boot and be taxable.
Delaware Statutory Trusts (DSTs)
Delaware Statutory Trusts (DSTs) offer several advantages. Skip the hefty up-front costs and tap into the same institutional-grade properties that historically required big bucks.
DSTs allow real estate investors to scale up their portfolios by gaining access to new asset classes – all while keeping their investment passively managed. However, investors should seek advice from tax experts due to the special rules surrounding DSTs. It’s not about one-size-fits-all solutions – what you need is tax advice that’s fashioned to fit your circumstances like a well-made suit.
Reporting Requirements
Proper paperwork is crucial for a successful exchange. When you exchange property, the deferred gain isn’t zeroed out. It’s added as a new depreciable asset with the deferred gain applied, increasing the new “asset value.”
If the purchase amount for the exchange property is less than the previous purchase amount, this doesn’t create a “loss amount” for tax purposes. Losses don’t roll over; only the gain is deferred.
Use Form 8824 to report your exchange, following the instructions carefully. “Boot” gains are reported on Form 8949 and Schedule D (Form 1040) or Form 4797. Be sure to understand the difference between property identified and property received to accurately report the exchange and manage your tax liability.
Example: The Power of IRS Code 1031 Exchange
Let’s say you sell an apartment building for $1 million. You bought it for $500,000. Normally, you’d face a large tax bill due to depreciation recapture, federal and state capital gains taxes, and net investment income tax.
With an IRS Code 1031 exchange, you can reinvest that $1 million into similar property, such as a multifamily dwelling or a Delaware Statutory Trust. A Qualified Intermediary helps find suitable replacement properties and ensures the exchange complies with all IRS rules. This is especially useful as a special rule applies when using a DST in a 1031 exchange.
Conclusion
An IRS Code 1031 exchange offers real estate investors a powerful way to defer taxes on property sold. Though there are rules and timelines, working with an expert simplifies the process.
Think of this strategy as a shield against taxes and a springboard for wealth growth – it helps you sidestep looming tax bills and watched your money multiply. A 1031 exchange enables reinvestment in like-kind real property while preserving capital for continued growth. When choosing a replacement property, don’t rush into it. A clear grasp of the relevant revenue procedure will save you from potential pitfalls down the line.