What are the benefits of a 1031 exchange?
The primary reason for a property or business owner to execute a 1031 exchange is to defer taxes on gains incurred on the sale of a property. In essence, you are able to redeploy capital into investments that are greater in scale, more diverse, or more aligned with your business or investment strategy. An example that illustrates this could be exchanging a parcel of vacant land for an income-producing property while deferring the tax liability incurred from the original sale.
Regardless of how you reallocate your portfolio within the IRS guidelines, the 1031 exchange strategy allows you more to reinvest at a time when real estate prices are at historic lows. Even if the property or building you are selling is depressed, deferring depreciation recapture is part of the equation.
What are the regulations of a 1031 exchange?
There are some strict rules and guidelines that determine what constitutes a valid exchange. The first stipulates the exchange must be between qualifying properties of like-kind. Most real estate, held for use in the trade of business or for investment, will qualify with the exception that they must both be within the borders of the U.S. Some personal property can also qualify for an exchange, but is not like-kind to real estate. Property that specifically would not be considered qualified includes inventory or stock in trade; stocks, bonds, or notes; other securities or debt; partnership interests; and certificates of trust.
Timing is another significant guideline that cannot be extended for any hardship or circumstance short of a presidentially declared natural disaster. There is a 180-day window during which the seller involved in the transaction must search, identify, and close on the purchase of the new property in order for the 1031 exchange to be valid. While more than one property may be identified initially, the property being purchased must be identified as part of the exchange no more than 45 days from the time the seller’s property is relinquished and closing on the new property must be complete within 180 days of the transfer.
The total purchase price of the property to be acquired must be equal to or greater than the total net sales price of the property being relinquished, and all of the equity received from the transaction must be used to acquire the property targeted in the 1031 exchange. If the replacement property purchase price is less than the relinquished property, a tax will be applied to the difference. Another fundamental rule requires that the net equity in the replacement property must be equal or greater than the net equity in the property sold, or the purchaser will be required to pay the tax on the amount of decrease.
Finally, the sale must also go through a qualified intermediary— simply selling the building or property and using the proceeds to purchase another disqualifies the exchange. These intermediaries are companies that work full time facilitating such exchanges. A qualified intermediary needs to be an independent organization that will handle the funds from the original sale through the exchange process and then deliver the money to the closing agent. The intermediary will also be responsible for filling out all of the appropriate tax forms and exchange agreements related to the process.
Does the current real estate market favor an exchange?
Every situation is different and an unbiased real estate professional can lay out all of your options to help you determine if a 1031 like-kind exchange is a feasible option. Owners selling their business may want to consider offsetting any gains on real estate by purchasing an income-producing property.
Depressed real estate values on one hand offer appreciation opportunity, while on the other hand limit the amount of quality real estate available for exchange. If the capital gains tax rate increases, experts would expect the amount of like-kind exchanges to increase.