As tax reform nears final passage in Congress, one of the most underrated, yet potentially overwhelming, tax-advantaged investment tools is the 1031 exchange, which has been spared major changes in legislation. proposed.

The 1031 exchange, especially when related to real estate investments, is all about “timing and taxes” and the better you manage the two, the more money you can make.

What is a 1031 exchange? Broadly, IRS Section 1031 covers “exchanges” or swaps of one specific investable asset (like real estate) for another. The end game for the taxpayer/investor is to avoid trades being listed as taxable sales. But if executed within the confines of a 1031 exchange, taxes are either greatly reduced or eliminated entirely.

The primary benefit of 1031 exchanges related to real estate investments is tax deferral or avoidance of capital gains taxes on the sale of valued investment properties, says Kevin O’Brian, Certified Financial Planner at Peak Financial Services in Northborough, Massachusetts.

“If held in the estate of the owner upon death, the asset would receive an increase in cost base to market value, beginning on the date of death,” O’Brian said. “Therefore, the heirs could avoid capital gains taxes, if they were also sold after inheriting.”

“1031 exchanges allow a real estate investor to sell a property that has appreciated in value and not pay capital gains tax as long as the investor buys another property,” says David Reiss, professor at Brooklyn Law School. “This is a powerful tax deferral tool that many sophisticated real estate investors use. It is however somewhat complicated to set up and involves additional cost and planning, so it is not for those who are looking for a quick and easy way to defer capital gains.

What are the rules of a 1031 exchange? The rules governing 1031 exchanges must be followed carefully, and it makes sense to plan it with an appropriate team of professional advisors and a reputable 1031 exchange company, Reiss says.

“Typically, the investor must sell the property that has appreciated; place the proceeds in escrow with an intermediary; then use that proceeds to purchase a replacement property within a certain time frame,” he says. “If the investor fails to meet the requirements of the exchange, they may be taxed on the entire capital gain.”

Investors should also make sure to use a 1031 exchange company that meets specific criteria. “Not the least of which is that it’s properly insured to protect you in case your funds go missing from escrow,” Reiss says. “This is known to happen.”

Some see a 1031 exchange as an IRS-sanctioned way to grow your real estate portfolio by deferring taxes, says Noel Dalmacio, CPA at Dalmacio Accountancy Corp., in Irvine, Calif.

But there are also many caveats.

“A 1031 exchange allows you to sell a property, reinvest the cash proceeds in a new property, and defer all capital gains taxes,” says Dalmacio. “If you do it right, you can build your wealth without paying taxes in the end.”

The first important factor is that the two exchanged properties must meet two critical criteria – like-kind property and qualifying property.

“A like-kind property simply means that the two real estate assets being exchanged must be of the same type or kind, even in cases where the assets vary in quality or grade,” Dalmacio explains. “Thus, exchanges between two properties, regardless of their use, would be qualified as exchanges of the same nature. For example, a single-family residence can be exchanged for vacant land.”

Both properties must also be classified as qualifying property, i.e. property held for investment purposes or for specific productive use in a trade or business. “Personal residence and some vacation homes are not eligible,” he adds.

For the purposes of real estate property of the same nature, Dalmacio offers the following examples:

  • Rental property for rental property
  • land for land
  • Land for rental properties
  • Enhanced properties for unenhanced properties
  • Office buildings for condominiums
  • Retail for apartment buildings
  • Trailer parks for hotels
  • Lease of 30 years or more for land
  • Common interest of tenants in real estate for rental properties

1031 stock investors must also adhere to the 45-day rule. “The replacement property must be identified within 45 days of the sale of the property you are giving up,” says Dalmacio. “No extensions are allowed.”

In terms of time, that’s not all – a 180-day rule is also in play.

“Property must also be purchased within 180 days of the sale of the property you are relinquishing or your tax return due date, including extensions, whichever comes first,” Dalmacio says. “Keep in mind that no extensions are allowed.”

Additionally, under IRS related party rules, related party exchanges will be disqualified if the seller or buyer disposes of the property within two years of the exchange. “The IRS will require you to report the capital gain or loss as of the date of the sale,” says Dalmacio.

Related parties may include spouses, siblings, parents, children, or a corporation or partnership of which you own more than 50%.

The 1031 exchange offers many opportunities for real estate investors to keep money away from Uncle Sam. Speak to a trusted tax professional and see if the IRS 1031 exchange is the right tax number for you.

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