If you’re a real estate investor, you know the game. You spend time acquiring appropriate and credible financing. You ensure the identified property is everything you want and can afford. You dream big, you work hard, and you put your precious money where you think it can grow.
Once you’ve derived the income from your investment property, for the purposes right for you, you’re ready to sell.
But what if the sale doesn’t go right? What if you’re faced with a lack of potential buyers, an excess of buyers, or not the right buyers? What if your investment property sits on the market forever and ever as your funds dwindle?
At NNN Deal Finder, we know what it’s like. We understand the kind of struggles an investment property owner endures when trying to make a sale. We’ve helped numerous clients generate predictable cash flows through a variety of low-risk, high-reward brand-name properties.
If you’re a seller looking to relinquish an investment property and move forward toward a replacement property, the 1031 Exchange may be the perfect fit for you.
What is a 1031 Exchange?
For real estate investors, a 1031 Exchange is a transaction detailed under Section 1031 of the Internal Revenue Code. This exchange allows a seller to direct sale proceeds from a sold property into a new, replacement property.
Depending upon the value of proceeds, other financings, and capital invested, a seller under the 1031 Exchange may be able to completely defer capital gains taxes.
However, there are certain very strict guidelines, rules, regulations, and laws that govern transactions under the 1031 Exchange. To enjoy the special tax treatment, investors need to first identify the right kinds of properties.
Once the right properties are identified, the sky’s the limit.
This is why many of the top real estate investment minds are using the 1031 Exchange to repeatedly defer taxes. By postponing the obligation to pay taxes, savvy investors can continue to reinvest money into investment properties that they otherwise may have struggled to finance.
This helps property owners generate passive income, build equity and capital, streamline financing, and diversify their asset portfolio.
Before opting for a 1031 Exchange, a prospective seller should ensure the current property comports with all applicable IRS requirements.
Understanding 1031 Investment Property and Replacement Property
The 1031 Exchange is unique for several reasons, but mostly because it provides a useful vehicle for savvy, forward-thinking investors to make the most of each successive property. However, not all properties qualify.
The investment property or property to be sold is called the relinquished property. Therefore, it is ‘relinquished’ in exchange for the new property. For a tax-deferred exchange to occur, both the old and new property must be considered like-kind property.
This is a specific, legally recognized term and fortunately can apply to all types of real estate assets.
What is a Like-Kind Property?
This term specifically applies to properties of the same nature or character. However, these properties can be completely different in their quality or grade.
If this sounds unclear, it’s actually quite straightforward. Most real estate properties within the U.S. may be considered like-kind to one another, as long as they are intended for business and investing purposes.
Remember, like-kind properties are not sold outright, but rather they are exchanged. They do not have to be of the same asset class. You can exchange vacant land for a single-family home, or a multifamily apartment complex for a medical center.
Residential, commercial, and industrial investment real estate may all be swapped for new property under a 1031 Exchange.
However, one’s personal residence or primary residence does not qualify as an investment property and therefore cannot be treated as exchange property. A vacation home, if used more than a certain minimum amount, will not qualify either.
Certain exceptions and criteria may apply.
Vacation Homes as Relinquished Property
Contrary to what many property owners and investors may think, vacation homes can and do qualify for a tax-deferred exchange under section 1031. You may be able to relinquish your vacation property if it meets the following criteria.
- Qualifying Use Period – The real property has been owned and held for at least 24 months before the initiation of the 1031 Exchange period.
- Rental Frequency Period – The real property has been rented at a fair market value no fewer than 14 days during the past two years.
- Investor Use Period – The real property has been used for personal use by the investor for fewer than 14 days during the past two years. If the property was personally used for less than ten percent of the number of days it was rented out over the past two years, it may also qualify.
In other words, your property is not like a primary residence. If you treat your so-called vacation home as a primary residence, then it will not qualify under the 1031 Exchange.
A seasoned real estate agent or real estate brokers’ firm may be able to assist you in your exchange. IRS Form 8824 is where you must report every 1031 Exchange.
However, before you identify relinquished and replacement properties, seek a qualified intermediary, or even begin to calculate potential capital gains taxes, you should understand the 1031 Exchange that is right for you.
Types of 1031 Exchange
If you have an investment property that qualifies under the 1031 Exchange, you have some choices ahead of you. There are four established 1031 Exchange types. Although they all share similar features, each has its own unique advantages and disadvantages.
Depending upon the relinquished property and replacement property, the seller and buyer needs and timetables, and the various purchase price and sales price considerations, any 1031 Exchange can vary significantly from another.
Whether you’re just hoping your first property sells, or have enjoyed major benefits from recurring exchange funds, you should always ensure you are aligned with the tax code.
Let’s cover some of the general principles and guidelines governing 1031 Exchanges.
The 45-Day 1031 Exchange Window
If you’re a seller looking to relinquish property, you’re looking to defer capital gains tax. However, if you’re not careful, you may invalidate the whole exchange, miss out on the benefits, and have to pay capital gains tax in full.
You have 45 days following the sale of your old property to designate replacement property. You must provide this designation to a qualified intermediary. The sale proceeds from your sold property will also go to this qualified intermediary who will secure the exchange proceeds in escrow.
The 180-Day 1031 Exchange Window
Once you’ve closed on the sale of the relinquished property, the countdown starts. You will have 180 days to then close on a property.
There are, of course, extraneous circumstances. For instance, sometimes sellers pass away before they can sell a property acquired through an exchange. In these cases, all tax liabilities are terminated. Any deferred taxes, no matter for how long, will not have to be paid by an heir.
With its appreciated value inherited as well, this tax exemption may be a sound way to plan estates.
Multiple Property Guidelines
Many real estate investors may not realize that they can exchange multiple properties under Section 1031. Oftentimes, one property is exchanged for another property, but there are also many advantages to swapping multiple properties.
If you have a second property in mind, or up to three properties identified for replacement, the value of the properties does not matter.
Exceptions to this rule include the 200 Percent Rule and the 95 Percent Rule.
Let’s say you want to sell a large estate and exchange it for various smaller properties. If there are more than three properties you want to exchange, they must total a value that is no more than 200 percent of the value of the sold property.
The 95 Percent Rule allows you even more freedom as a seller and buyer. In this case, you can exceed the 200% cap, but you have to close on 95% of the replacement property value. In this sense, you can theoretically exchange for as many properties as you want.
However, this is often difficult for even an experienced real estate agent.
Nonetheless, if you have the right properties and circumstances aligned, real estate professionals can assist you to maximize your property exchange process under Section 1031.
Various 1031 Exchange types may be a perfect fit for your real estate investments.
The Delayed 1031 Exchange
As the most common 1031 Exchange for real estate investment, this swap requires that the seller relinquishes the old property before the acquisition of the new property. Exchange proceeds are invested into the new property.
Before the exchange process is initiated, a sale and purchase agreement must be completed, and a qualified intermediary must initiate the relinquishing of the old property. The funds are held in escrow for up to 180 days or until the sale is closed on the replacement property.
The delayed exchange is common because it permits ample time for sellers and buyers to identify investment properties for exchange, locate a qualified intermediary, secure the necessary funds, and close on the transactions.
The Simultaneous 1031 Exchange
This is one of the least common exchanges under Section 1031, mainly because it requires the relinquished and replacement properties to close on the same day at the same time. This is often difficult, even with the help of a qualified intermediary, because equity and debt must match.
If these structures don’t match, ‘boot’ may be required. The boot is additional cash or physical property and may be taxable. In a 1031 Exchange specifically, boot is the portion of sales funds that don’t get re-invested.
In some forms of simultaneous exchange, a so-called accommodating party facilitates the transaction. However, real estate experts do not recommend this approach as the accommodating party is essentially taking a property title for a property about which they know very little.
This method of simultaneous exchange is also discouraged because it requires minimal documentation. This makes it difficult to prove aspects of the exchange process if issues arise in the future.
The Reverse 1031 Exchange
This is essentially the reverse of the delayed exchange. In this exchange, the first property of consideration is the replacement property. The seller acquires this property through a qualified intermediary or titleholder before relinquishing the old property.
The reason reverse exchanges are uncommon is because they typically require full cash payments. It is often difficult to convince banks to provide loans for investment properties in these exchanges.
This happens for various reasons.
Firstly, the primary loan must be in the name of the entity ‘parking’ the funds and not in the name of the seller/buyer. A unique loan type is required in this case that can be refinanced later into a long-term loan. Because this is an atypical lending structure for many banks, they often do not grant the loan.
Investors with full cash, however, may be able to negotiate the process relatively smoothly.
The normal 45-day and 180-day windows still apply. However, if the asset is not relinquished in 180 days, then two assets are owned. This is why a qualified intermediary is so critical throughout the process.
The property type of the original property and the replacement property are factors that may greatly complicate a 1031 reverse exchange. Top legal advisors, brokers, and agents can all facilitate the process.
The Construction/Improvement 1031 Exchange
This 1031 Exchange type may be ideal for investment real estate that requires repairs, fixes, and capital improvements. In this exchange, the taxpayer identifies a replacement property as he or she would in a normal delayed exchange.
For full deferral on capital gains taxes, the seller must use all the sales proceeds from the relinquished property to improve the new property. Meanwhile, a qualified intermediary will hold the replacement property for the rest of the 180-day window.
If you don’t want to pay taxes on capital gains, ensure you spend all of the exchange equity on improving the new property, or as a down payment for the new property.
When the improvements are finished by the 180th day, the replacement property must be “substantially the same property” as it was when identified in the 45-day window.
The property should still be of equal or greater value and the renovations must be complete before the qualified intermediary can return the title to the seller.
Overall, there are many ways to avoid taxable income and defer taxes through a 1031 Exchange. Although Section 1031 used to apply to personal property, that has since changed following the Tax Cuts and Jobs Act.
Under Section 1031 currently, only real property qualifies, whether it be a real estate asset that is industrial property, commercial property, or residential property.
This affords real estate investors many opportunities to avoid paying taxes while investing their tax savings into newer, better, and more profitable properties.
Understanding Capital Gains Tax Deferral
Realty investors use the 1031 Exchange because of its tax benefits. With smart and sound investment properties, investors can minimize taxable income, even avoiding capital gains taxes for years.
Some real estate investors never pay a cent on their capital gains by continuously rolling the proceeds into the next investment. Then, when they die, their heirs inherit the investment without tax liability.
Whether you’re deferring taxes on an apartment building, a single-family home, or some commercial or industrial property, you need to know how to accurately defer taxes. For 100% capital gains deferral, the replacement property must be of equal or greater value than the relinquished property.
The ‘Equal or Greater’ Value Rule
There is a common misconception among investors that the ‘equal or greater’ rule applies to the purchase value of the new property and the selling value of the old property. In reality, the value of the sales proceeds, or exchange funds, is a combination of equity, debts, and profits from the sold property.
The exchange funds from the sold property may be substantially lower than initially thought. Transaction fees associated with the sale must be considered. Other expenses must be considered, such as sales commissions, escrow fees, inspection costs, legal expenses, title insurance fees, and other relevant expenses.
When entering a 1031 Exchange, every investor should understand the property’s market price, how much it cost initially, as well as the debt and the equity in the property.
For instance, imagine the current selling price is $600,000, but it was purchased initially for $550,000. Then let’s assume the investor has $250,000 in equity and $300,000 in remaining debt. The selling price of $600,000, therefore, addresses the equity, debt, and transaction fees of $40,000. In the end, the investor enjoys a profit of $10,000.
Thus, the exchange fund value is $560,000 or equity + debt + profit.
Assuming the acquisition fees of the replacement property are $10,000, the value of the new property can be $550,000 and qualify as equal or greater. In terms of equity and debt, the new property’s equity and debt can also fall under the rule of equal or greater.
In this case, the new total of equity and debt must be at least $560,000 for tax deferral.
When a seller pursues a property of greater value, they can take on external financing or contribute personal money and qualify under Section 1031.
You don’t need to be an investment banker, lifetime real estate agent, or tax policy expert to approach this process. If you’re struggling or uncertain, simply consult a professional to work on your behalf. With a top investment mind at your behest, you can make the most of a 1031 Exchange for capital gains deferral.
Calculating a Property’s Net Adjusted Basis
When calculating your potential capital gains taxes owed, you need to know what is called the net adjusted basis. A property’s net adjusted basis is essentially the following equation: initial purchasing price plus capital improvements minus depreciation.
More specifically, the net adjusted basis also adds on sale costs, before subtracting any tax deductions for the asset.
The net adjusted basis is a main aspect of the capital gains formula. Put simply, your taxable capital gain is the difference between the selling price of the property and purchasing price. Of course, these values include many related and separate expenses, fees, and costs.
If the number-crunching is too confusing and overwhelming, you’re not alone.
For now, it’s best to understand the importance of the net adjusted cost basis. In determining this figure, you can first calculate your cost basis by adding up the cash, debts, services, and other property you included in the purchase price.
These may include:
- Sales Tax
- Real Estate Taxes
- Legal/Accounting Fees
- Installation Expenses
- Recording Fees
Once you have this cost basis, you need to know what to add and deduct from it. Improvements are to be added as well as other sales costs. Certain expenses should be added to the basis. These may include:
- Legal Title Fees
- Zoning Expenses
- Certain Utility Connections
Then there are expenses you must deduct from the basis.
These may include:
- Investment Credits
- Energy Credits
- Postponed Gain
- Gas Tax
- Depletion Deductions, and more
With these additions and subtractions, you should arrive at your property’s adjusted net basis. You will also need to consider what is called depreciation recapture. Many people know about capital gains but fewer understand depreciation recapture.
As it turns out, a 1031 Exchange allows you to not only defer capital gains but also defer depreciation recapture from the property’s sale. Essentially, depreciation recapture tax is the taxation of a depreciated asset when sold.
Any gain that can be attributed to depreciation taken during property ownership is subject to taxation. This accumulated depreciation over the years is usually taxed at an ordinary income rate of 25% and can be quite onerous if not for the 1031 Exchange tax treatment.
In other words, depreciation recapture is determined when the property sells for a higher value than the adjusted cost basis. In some cases, depreciation recapture tax may be greater than capital gains tax, meaning you can effectively defer significant bills!
The passive investment of a 1031 Exchange property carries great potential. If you can successfully and strategically postpone paying taxes on a first property, second property, or even a hundredth property, you can vastly increase your wealth and diversify your asset portfolio.
However, you shouldn’t go it alone. Don’t let your hard-earned money go to waste. Consult a top-notch investment specialist to begin your investment legacy today.
Succeeding as a 1031 Exchange Seller
Clearly, there are many ways in which a 1031 Exchange can benefit the seller. Whether you’ve identified a single suburban rancher to exchange, or you’re looking to relinquish large apartment complexes for numerous and varied properties, you need to know what you’re doing.
Don’t let your hard-earned cash and capital go to waste. Don’t struggle with dubious financing, predatory lenders, confusing mortgages, and IRS legalese. Don’t fall victim to unexpected interest rate risks, fees, and expenses.
If you want to generate a durable, reliable income stream, if you seek to create sustainable and robust wealth while deferring onerous taxation, the 1031 Exchange is your vehicle of choice.
So what is it going to be? Will you secure your future today by investing in top residential, commercial, and industrial properties? Will you align yourself with sterling investment experts with a proven track record of success, or will you risk your livelihood, your future, on poor investments?
The investment game is unforgiving.
At NNN Deal Finder, we are the premier broker for savvy investors who want long-term leases with reputable brands. Our low-risk, high-reward approach has delivered for numerous clients across the spectrum of 1031 sellers and buyers.
With our entrenched network of owners, developers, and real estate experts, we can connect clients with the best triple-net (NNN) properties around.
If you’re an investor looking to make the most of a 1031 Exchange through reputable brand properties, we have the experts you need. Our personalized advisory advice is here to optimize your investments, every step of the way.
So don’t lose time, money, and sleep overseeing your properties, managing tenants, or handling maintenance. Learn about NNN leases and turn your earnings into mailbox money. Call our specialists today.