Investors in the real estate industry can utilize 1031 exchanges to defer the payment of capital gains taxes when they sell an investment property and use the proceeds to reinvest in another property. It is important to note that if you choose to complete a sale and purchase outside of a 1031 exchange, you will be liable to pay capital gains taxes on the difference between the adjusted basis and the sale price of the property.
Suppose you purchased a piece of land for $250,000, which included the acquisition costs, and spent $100,000 on improvements, making your adjusted basis $350,000. After holding the property for five years, you decide to sell it for $600,000. This means that you will owe capital gains taxes on the difference between the sale price and the adjusted basis, which is $250,000. Depending on your tax bracket, you could owe up to $50,000 in taxes.
If you sell an investment property and choose to conduct a 1031 exchange, you can reinvest the proceeds from the sale into a new property while adhering to the procedures and timelines that the IRS created for the transaction. By doing so, you can reinvest the entire amount of the sale, which in the example provided was $600,000, rather than just $550,000. However, there are several essential requirements you must follow to qualify for this tax-deferred exchange:
● Firstly, you must use a Qualified Intermediary to manage the process. The QI creates an account to hold and manage the proceeds between the initial sale and the final acquisition.
● Secondly, you must identify potential replacement properties within 45 days of the sale and complete the purchases, or purchases, within 180 days from the start. This means that you have 45 days to provide a written list of potential replacement properties to the QI and 180 days to complete the purchase(s) of the replacement property(ies).
● Lastly, it's important to note that the value and debt levels of the replacement property must match or exceed that of the relinquished property. In other words, the replacement property must have a purchase price equal to or greater than the relinquished asset, and you must also swap an equal or greater amount of debt.
Completing a 1031 exchange can be a complex transaction with strict timelines to adhere to, but the potential tax deferral can offer significant advantages. One of the benefits is the ability to use the exchange for subsequent investments, leading to a transfer when you pass away. At this point, the heir will inherit the property at its stepped-up value, eliminating any deferred taxes. This feature has the potential to create an excellent opportunity for investors to continue growing their investment portfolios while mitigating their tax liability.
Can I Build on the Property?
If you're considering building on a replacement property acquired through a 1031 exchange, there are specific guidelines you need to follow. If the replacement property's value equals that of the relinquished property, you can proceed with the exchange and make any desired improvements to the replacement property. However, if the replacement property's value is lower than that of the relinquished property, you'll need to make improvements to bring its value up to par.
The catch is that all the necessary improvements must be completed within the 180-day period allowed for the exchange. Additionally, you'll need to outline the planned improvements within the first 45 days after identifying the replacement property to be eligible for the exchange. It's essential to work with a qualified intermediary and seek professional advice to ensure you comply with all the rules and regulations of a 1031 exchange.
Can I Transact a 1031 Exchange into New Construction?
The 1031 exchange allows real estate investors to defer paying capital gains taxes by reinvesting proceeds from the sale of an investment property into a replacement property. However, one of the key requirements is that the value of the replacement property must be equal to or greater than the value of the relinquished asset. This requirement can make it challenging to use a 1031 exchange to build on a replacement property.
For instance, if an investor is selling a retail property and wishes to build a multifamily housing structure on vacant land, they must ensure that the value of the new asset is equal to or greater than the original property. If the new acquisition is of lower value until construction is completed, the investor must complete the construction by the end of the 180-day period. During this time, the title must be held by a qualified intermediary.
It is important to follow the rules and timelines of a 1031 exchange to avoid disqualification and to ensure a successful exchange. Investors should also work with a qualified intermediary to manage the transaction and help navigate any complexities. By doing so, they can leverage the potential benefits of a 1031 exchange and potentially defer paying capital gains taxes on their real estate investments.
Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
- There’s no guarantee 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;
- 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 potential for foreclosure;
- These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- 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