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1031 exchanges help investors transition to new investment strategies

Every sale of investment or business property can create a tax liability. This reduces the amount of money available for the purchase of replacement property and can performance temper growth.

In 1921, the IRS addressed this problem by setting up a re-investment incentive known as a Section 1031 or “like-kind” exchange. Companies and real estate investors have since relied on these exchanges to defer tax bills. Prior to the Tax cuts and Jobs Act of 2017, like-kind exchanges included a wide variety of property types, such as machinery, vehicles, cryptocurrencies and livestock. Under the new law, only real estate like-kind exchanges are allowed.

In a 1031 or like-kind exchange (exchange), an investor can swap one or more existing properties for one or more properties of comparable value. If the like-kind property is purchased with the profits gained by the sale of the first property, the investor can defer capital gains and more money for reinvestment.

It’s a handy tax-deferment strategy for an investor that wishes to change their investment strategy. Hands-on properties can be exchanged for managed properties when investors wish to slow down and assume less responsibility. And, less desirable properties exchanged for properties in stronger growth markets.

How it works

When an investment property is sold, the seller is on the hook to pay capital gains tax. Using an exchange, the investor can trade like-kind properties without incurring a sudden tax obligation. To qualify as a 1031 exchange, the property being sold (original) and the property being acquired (replacement) must be like-kind, meaning the same nature or character, and located in the U.S.

An exchange can be applied to most properties, except personal property. This includes apartments, single-family dwellings, commercial office building, rental property, and restaurants.

As long as the properties are like-kind, the number of properties being exchanged is irrelevant: an investor can exchange one property for multiple replacement properties or exchange multiple properties for one larger property.

Several conditions must be met to take advantage of the tax benefits, including:

  • A 1031 exchange is applicable for investment or business property only, not personal property. An investor can’t swap their primary residence for another or a primary residence for a vacation property.
  • The name on the title of the property being sold must be the same as the name on the tax return, unless the buyer is a pass-through entity.
  • The exchange must be completed within 180 days of the sale of the exchanged property or the due date of the income tax return in the tax year the relinquished property was sold, whichever is earlier.

Types of exchanges

Originally, a like-kind exchanges occurred simultaneously when a relinquished property and replacement property closed on the same day. However, a simultaneous exchange can be tough to pull off.

Alternative types of exchanges have arisen to account for timing differences in the purchase and sale of property and allow for property improvements. Investors can delay, or forward, an exchange by relinquishing the original property before acquiring replacement property, provided timing requirements are met.

In a reverse exchange, an investor acquires a replacement property and then sells the relinquished property within specific time frames. And finally, an improvement or construction exchange allows an investor and developer to make improvements on the replacement property using tax-deferred dollars.

Timing a 1031 exchange

Avoiding paying capital gains taxes now can be a big advantage to investors in like-kind property exchanges. But executing a 1031 tax-deferment is complicated and carries traps for the unwary. Phil Jemmett for HuffPost captures a number of potential drawbacks to consider and manage, including:

  • Multiple procedures, rules and regulations to follow.
  • Reduced basis on property acquired.
  • Losses cannot be recognized.
  • Only tax deferred, not tax-free.

For these reasons and more, timing a 1031 exchange is not a do-it-yourself project. Contact your Wambolt advisor to learn more about the pros and cons and various options available through a 1031 exchange.

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