If there’s one thing that real estate investors want, it’s a property that guarantees a comfortable, predictable income. There’s no reason to waste time, resources, and effort. If you’re a savvy investor looking for a robust passive income, you can get it.
Through the right mechanisms, with the proper approach, guided by a strong real estate professional, any investor can finally enjoy what matters.
If you’re looking for an investment property that delivers strong passive income, we can help. At NNN Deal Finder, we know the best investment deals for commercial real estate, and it all starts with a 1031 Exchange.
We help prospective clients create the durable, dependable passive income they want. If you’re a buyer, there are many ways a 1031 Exchange can affect you.
Making Sense of the 1031 Exchange
1031 Exchanges are a great option for real estate investors seeking to diversify their investment property portfolios, expand their income streams, and solidify themselves as major players in their markets of choice.
By taking advantage of a 1031 Exchange, investors can enjoy various benefits relating to capital gains taxes, new property options, and fair market trends. A qualified intermediary can help ensure the entire process goes smoothly.
Overall, 1031 Exchanges are a great option for smart investors looking to make the most of every investment property in their portfolios. As the buyer of a new property, whether one property or multiple properties, you have the opportunity to save significantly on deferred taxes.
IRS Definition of 1031 Exchange
Under Section 1031, an investor can take the money from a sold investment property and use it to purchase a so-called replacement property. However, the properties must be similar and the profit from the sold property must be used strictly for investment property.
Investors cannot use these sale proceeds for their personal property or primary residence. Moreover, they cannot exchange a secondary dwelling, like a vacation home or beach house, under a 1031 Exchange.
Additionally, under IRC §1031(a)(2)(D), no partnership interest can be exchanged.
Be sure to consult 1031 Exchange experts and discuss with a qualified intermediary to determine the best way to move forward with exchange funds.
According to the IRS, a Section 1031 Exchange directly permits an investor to put off having to pay capital gains taxes as long as exchange proceeds are invested in similar qualifying property.
One thing that investors should understand is that a tax-deferred exchange is not a tax-free exchange. You are not free of paying taxes entirely. The tax payments are merely ‘postponed.’
Under 1031 Exchanges, investors can exchange only similar, or like-kind, properties, or they can exchange property as well as cash, liabilities, and non-qualifying property.
However, the second case may result in a taxable gain for the tax year in which the exchange takes place.
If you want to completely defer federal taxes, the replacement property must have equal or greater value than the relinquished property. A qualified intermediary can help you explore related options if the value is not equal or greater.
The following types of property do not qualify under 1031 Exchanges:
- Stocks, bonds, or notes
- Inventory or stock in trade
- Certificates of trust
- Partnership interests
- Other securities or debt
All in all, for a 1031 Exchange to be used for realty, you must ensure that it is done so for business or investment purposes, that the property is inside the U.S., and that the replacement and relinquished properties are like-kind.
Like-Kind Replacement Property and Relinquished Property
For properties to qualify under a 1031 exchange, both the relinquished property and the replacement property must be what is called like-kind. This term does not refer to property condition or quality. One property can be old and dilapidated, another can be relatively new.
What matters is that the properties are of the same nature, character, or class. This does not include a primary residence or personal property, which cannot be exchanged properties.
That said, properties identified that are located in the U.S. and used for business or investment purposes will typically qualify under 1031 Exchanges. This can apply to a variety of properties, including an apartment complex, home, multiplex structure, single-family rental, commercial real estate, and more.
A savvy real estate investment specialist or qualified intermediary can help investors determine which exchanges are viable and which properties qualify under the law, rules, and regulations.
Generally, most real property is considered like-kind to other real property being used for business or investment reasons. Investment property buyers should be aware of the following considerations:
Geographic Location
It doesn’t matter where the properties in the exchange are located, as long as they are located within the U.S. State jurisdictions and other zoning considerations do not affect the like-kind status.
Asset Type Differences
The asset class of replacement property may differ significantly from that of a relinquished property. For example, commercial land may be exchanged for a residential single-family home. Vacant land may also be exchanged if intended for investment reasons.
Whether developed or undeveloped, commercial or non-commercial, property may qualify under a like-kind 1031 Exchange.
IRS Reporting Requirements
We all know how difficult it can be when filing season comes around and it’s time to pay taxes. Not only can it be stressful, but it also may leave us scratching our heads, gnashing our teeth, and looking around for help.
The last thing you want to do is lose sleep over stressing about tax consequences and tens of thousands or hundreds of thousands of dollars in liability. With the right funding options and lending services provided, these worries can all but disappear.
Fortunately, 1031 Exchanges allow appropriate parties a degree of freedom when it comes to real estate and making money. Just remember, a primary residence is not permitted for exchange.
Nonetheless, there are certain rules and regulations that must be followed. You must report a like-kind exchange on form 8824 and file it with your tax return for the year of the exchange.
You will be required to report:
- Relationship (if applicable) between exchanging parties
- Paid or received cash, and assumed or relieved liabilities
- Value of like-kind and any other property exchanged
- Property descriptions
- Dates of property identification and transfer
- Gain or sale loss of any non-like-kind property relinquished
- Adjusted basis of relinquished like-kind property, and realized gain
If you have any difficulty with these terms, providing this information, or completing the required documentation, you should consider consulting a 1031 Exchange expert. A qualified intermediary may be able to assist, or at least point you in the right direction.
Property Owners’ Rights
Some property buyers have permanent rights whereas others have only temporary rights about different aspects of the property. These rights are irrelevant when determining like-kind status.
Value Differences
A relinquished property and a replacement property may differ in market value, lot size, history, age, and more. These are measures of quality and do not preclude the property from qualifying under a like-kind 1031 Exchange.
Of course, if you wish to receive 100% capital gains tax deferment you have to have a replacement property whose fair market value is of equal or greater value. As long as the replacement value does not exceed 200% of the relinquished property value, you can exchange.
However, there are exceptions to this rule.
Just remember, your personal property, vacation home, and primary residence do not qualify.
Number of Properties
When replacing sold properties, you can have as many as three replacement properties without impacting tax-deferment consideration under the rules of the 1031 Exchange. As long as you have no more than three properties for replacement, you are following the “three property rule.”
You may also factor in associated fees and costs, such as inspector or broker expenses when determining the full costs of new properties.
Overall, there are many ways in which savvy investment property buyers can use their properties under a 1031 exchange. These exchanges may play a critical role in expanding and diversifying one’s portfolio, increasing passive income streams, and establishing low-risk, high-reward opportunities.
Many potential replacement properties can be purchased under a 1031 Exchange real estate transaction. The benefits for buyers using this real estate investment strategy are numerous.
With the investment guidance, expertise, and experience of a qualified intermediary, you can make the most of your real property 1031 Exchange.
Advantages of Using a 1031 Exchange for Investment Property
Although many investors of replacement property and relinquished property are aware of the obvious tax deferral benefits, not having to pay taxes right away is only one of the benefits of a 1031 Exchange.
Whether you’re concerned about capital gains tax liability, looking to expand your property portfolio, or simply want a way to continuously defer taxes while enjoying robust income streams, the 1031 Exchange can make it happen.
Multiple options exist within this framework that many of the top realty investors have used to their benefit.
Ease of Property Diversification
Aside from the financial advantages of tax deferral, 1031 Exchanges also allow investing persons to diversify with investment properties located throughout the country.
Not only is this permitted without the IRS looking over your shoulder, but it also allows you to take on new projects of a lesser workload.
For instance, you may be able to switch from long hours managing home real estate to having a property management company oversee your new apartment replacement property. In the end, you can streamline your passive income while using exchange funds in a manner compatible with the internal revenue code.
In the end, you can make larger down payments for one or more properties that you might otherwise have struggled to afford. This is a top advantage in wealth accumulation and portfolio expansion.
Planning Estates
Typically, when real property owners sell real estate and acquire replacement property, the capital gains taxes are deferred. However, if the buyer dies during this exchange, an heir may be able to receive the property tax-free.
In cases like this, the property has an increased market value and deferred taxes are waived. A qualified intermediary may offer the professional guidance required in such a scenario.
Deferring Capital Gains Tax
Most seasoned real estate investors have taken advantage of appreciation and equity to build a strong position in the market. With a consistent and productive focus on property management, investors can expect to enjoy a healthy capital gains tax deferment under a 1031 Exchange.
If you sell a property for more than the replacement property value, you will be assessed the standard income tax amounts on the differences. This is called the ‘boot’ and will incur capital gains tax.
Several factors impact your capital gains tax deferment. These depend on your income tax bracket and the duration of time you’ve had the property. Brackets include 0%, 15%, and 20%.
You should consult a qualified intermediary for 1031 Exchange specialists to help you stay in line with the tax code. Together, a qualified intermediary and 1031 Exchange specialist can assist you in relinquishing your property, securing your proceeds, finding qualified property, and making the purchase.
Methods of 1031 Exchange
Although the most common form of 1031 Exchanges is to sell a property and then buy a new one, this is only one type. There are essentially four ways in which one can conduct a 1031 Exchange. Each varies depending upon investors’ needs and goals, market factors and trends, and the buyer-seller dynamic.
Delayed 1031 Exchange
Simply put, this method of forward exchanges permits the investing party to sell the property and then take up to 180 days to hire a qualified intermediary, put the proceeds in a binding trust, and secure a like-kind replacement property.
The delayed exchange is the most common type of 1031 Exchange. A qualified intermediary serves to establish and finalize the contracts for exchange funds, relinquished property sale, and procurement.
Delayed exchanges are beneficial because they provide a flexible time frame. The generous 180 days mean that taxes from delayed exchanges are deferred till at least the next year.
Simultaneous 1031 Exchange
Unlike a delayed exchange, this method of exchange transaction occurs with both relinquished and replaced like-kind properties closing at the same time. Also called drop-and-swaps, these exchanges accelerate the process and are ideal for parties that are under time pressure and already have the necessary details in place.
It is wise to seek the expertise of a qualified intermediary in such a case. A title company can also serve an escrow function while the buyer works to identify replacement property.
1031 Reverse Exchange
Like-kind reverse exchanges simply reverse a standard forward exchange. An exchange accommodator acquires and ‘parks’ the property to be bought. After 45 days, the person exchanging has to identify in writing any potential relinquished properties to be exchanged.
By the 180-day mark, the exchange accommodator can either transfer the parked property to the person exchanging it or to a third-party buyer.
Overall, reverse exchanges simply require that the taxpayer takes on the replacement property before exchanging the relinquished property.
Improvement 1031 Exchange
An improvement exchange allows sale equity from the relinquished property to be used in renovating and improving the potential replacement property. After 180 days have passed, the proceeds must be spent improving the property and the property must be finished.
This can be difficult to do in only 180 days, unless the improvement process is either relatively minor or expedited. Once the improvements are finished, the replacement property cannot be significantly different.
The improved property must still be “substantially the same property,” with an equal or greater value.
Overall, there are many ways in which taxpayers and investors can use the 1031 Exchange rules to their benefit. The buyer can enjoy low risks and high rewards that repeatedly defer taxes, boost diversification, and generate greater income.
With the help of a professional such as a qualified intermediary, real estate agent, broker, and more, any savvy real estate investor can gain from the exchange process.
Calculating Important Buyer Costs and Fees
Because a 1031 Exchange can be used for a full range of like-kind real properties, buyers have many options. While this freedom is certainly liberating, it can also be confusing and overwhelming for indecisive buyers.
Before you enter a 1031 Exchange and look to relinquish and replace property, you should consider potential numbers and figures that may impact your current and future finances.
Some buyers want residential properties. One buyer might exchange for a larger single-family home to rent, whereas another buyer might be interested in industrial property or business property such as a general store or office building.
The range of opportunities is boundless, but only if the exchange is made with the right numbers in mind. Several important calculations must be considered.
How to Calculate Property Basis
A property’s net adjusted basis is the purchase price plus capital improvements minus depreciation. If that sounds confusing or unclear, don’t worry. Generally, the term refers to the cost of a property. Upon original purchase, the basis is the price paid as well as the costs of acquisition.
In a 1031 Exchange, there are several steps required to calculate the final cost basis.
Depreciation Basis Calculation
First take the purchase price of the property being sold, the relinquished property, and add in closing costs. Then, add this number to capital improvements. These may include various renovations made to increase the value or life of the property. Fixes, maintenance expenses and loan costs are not included.
The next step is to subtract any depreciation before the exchange. Depending on if the property is residential, commercial, or industrial, the percentage per year will vary. This final figure is the depreciated basis.
Realized Amount Calculation
Now that we know the depreciated basis, it’s time to calculate the relinquished property’s realized amount. Take the closing costs your closing agent takes from selling the property and subtract them from the sales price. This results in the realized amount.
Replacement Property Cost Basis
Aside from the relinquished property, the new property costs are also an important calculation. This simple equation is the sum of the buying price and commissions. Add the buying price and costs of closing, and you get the cost basis for the new property.
Final Basis
Using the previous figures obtained, you can calculate the final cost basis. Begin by subtracting the realized amount from the replacement property cost basis. Then add that number to the depreciation basis.
For example, if the replacement property cost basis is $500,000 and the relinquished property’s realized amount is $400,000, the difference is $100,000. Then add $100,000 to the depreciation basis. If the depreciation basis is $350,000, the final cost basis is $450,000.
Any gain is therefore part of the tax-deferred exchange. The beauty of such tax deferred exchanges is that you can proceed to defer taxes on gains, repeatedly, as long as you are exchanging. This can allow for numerous opportunities to invest, enrich and diversify.
Succeeding as a Buyer
There are many reasons for buyers to use a 1031 Exchange. A smart strategy for savvy taxpayers, this legal and lawful mechanism can be used for continuous property investment. Many investors struggle with the IRS. They are afraid to take risks, or when they do take risks, the risks are too big, too bold, and too burdensome.
Fortunately, there are many low-reward, high-risk options. One way to make the most of these exchanges is through triple-net (NNN) properties. These commercial properties provide predictable cash flow, strong appreciation, and wide diversification.
With the tenant covering the bills for both rent and traditional landlord costs, such as property taxes and insurance premiums, NNN properties have the potential to be tremendous investments. When exchanged under Section 1031, these properties can be especially profitable.
At NNN Deal Finder, we know all the ins and outs of commercial real estate. Through our 1031 Exchange expertise, we can help you exchange up for numerous properties and business types, including auto ad brake, general retail, restaurants, pharmacies, fast food franchises, gas stations, and medical offices.
We have an established network of inspectors, real estate agents, brokers, contractors, and more that you need.
So don’t miss out on mailbox money. Enjoy strong investment with predictable returns while you create the lifestyle you want. Give us a call or shoot us an email and let’s start your journey today.
It’s time to generate the passive income you’ve always wanted.