While 1031 Exchanges have been around for almost one hundred years, there are enough nuances that they are not always fully understood by even experienced real estate investors.
The 1031 Exchange process involves selling an investment property and reinvesting the proceeds in a like-kind property while deferring capital gains and depreciation recapture taxes. The complexity is around the details, deadlines, process, and procedures.
This article will explore 1031 Exchange basics.
In a traditional real estate transaction, an investor can expect a tax liability as much as 40% of the taxable gain without accounting for property improvements and sales costs. Being able to defer taxes makes it possible for an investor to seek a different type of investment, diversify holdings, expand their portfolio, or realign investments with long-term goals.
A Qualified Intermediary (QI) must be part of every 1031 Exchange, facilitating the exchange and making sure the investor does not take possession of the proceeds from the sale of the relinquished property. The QI assists the investor to properly identify “like-kind” properties as options for the new investment, and may inform the investor of optional 1031 approved investment structures such as Delaware Statutory Trusts (DSTs), and can help ensure that the exchange process goes smoothly and results in a successful outcome. It is important to carefully select the QI and to know that your intermediary cannot be your broker, attorney, an employee, or yourself.
The new property must be a like-kind investment, but it is not as limiting as requiring a single-family house be exchanged for a single-family house or a commercial building for a commercial building. Personal property like a vehicle, the family’s vacation house, and stocks and bonds cannot be included in the exchange, but most business investment real estate, such as single-family rental homes, apartment complexes, commercial buildings, and vacant land qualify.
A popular 1031 Exchange option is a Delaware Statutory Trust (DST). Instead of having full ownership of a property and full responsibility of the day-to-day management of the property, a DST is a passive investment in which an investor owns beneficial interests in trust that the IRS has determined can be equivalent to holding title in real estate. DSTs can offer minimum investments as low as $50,000 and typically are structured to be held for up to ten years. They are considered illiquid investments, so exchangers should be comfortable with longer hold periods before investing.
From the date that the original property sells, the investor has 45 days to identify a replacement property and 180 days to complete the purchase of the replacement property. Except for rare instances when the government may allow a delay e.g., fires, hurricanes, pandemics, there are no extensions and no exceptions. It often helps, whenever possible, to have a plan in place and an understanding of how the 1031 Exchange process works before completing the sale of the relinquished property.
Within that 45-day window, an investor can identify up to three replacement properties, giving the investor options in case the purchase of the preferred property falls through or if the plan is to purchase multiple replacement properties. More than three properties can be identified during the 45-day window as long as the combined value does not exceed 200% of the value of the relinquished property’s gross sale price. The 200% value requirement can also be exceeded, and unlimited properties identified as long as at least 95% of the combined value of the identified properties is purchased (although this last rule is rarely followed). Failing to meet any of these rules disqualifies the exchange and would trigger the tax obligations.
A 1031 Exchange is typically a long-term investment, but if the investor needs some of the proceeds from the sale of the original property, it is possible to complete a partial 1031 Exchange. In this instance, a percentage of the proceeds may be distributed to the investor subject to taxes paid on the portion of the appreciated gains that were not exchanged, and the remainder is reinvested in a like-kind real estate property.
These basics will help you get started on your 1031 Exchange journey, but it is always best to speak with your financial advisor or tax professional about your individual circumstances.
For more information on 1031 Exchange tax deferral strategies, please contact First Guardian Group at 866-398-1031 or info@FirstGuardianGroup.com. You can also schedule a one-on-one consultation with Paul here.
Disclosure: DSTs, like all real estate, have risks, including illiquidity, potential for loss of property value, costs and expenses that could offset the benefits associated with tax deferral, and reduction or elimination of monthly cash flow.
Disclaimer: There is no guarantee that any strategy will be successful or achieve investment objectives. All real estate investments have the potential to lose value during the life of the investments. This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please be aware that this material cannot and does not replace the Memorandum and is qualified in its entirety by the Memorandum.
This material is not intended as tax or legal advice so please do speak with your attorney and CPA prior to considering an investment. This material contains information that has been obtained from sources believed to be reliable. However, FGG1031, First Guardian Group, LightPath Capital, Inc., and their representatives do not guarantee the accuracy and validity of the information herein. Investors should perform their own investigations before considering any investment. There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) and 1031 Exchange properties. These include, but are not limited to, tenant vacancies, declining market values, potential loss of entire investment principal.
Past performance is not a guarantee of future results: potential cash flow, potential returns, and potential appreciation are not guaranteed in any way and adverse tax consequences can take effect. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All financed real estate investments have a potential for foreclosure. Delaware Statutory Trust (DST) investments are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions. Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits.
IRC Section 1031, IRC Section 1033, and IRC Section 721 are complex tax codes; therefore, you should consult your tax and legal professional for details regarding your situation.