Despite interest rates remaining at historically low levels, it’s not often that you get to borrow money for free. The IRS, not typically known for its generosity, allows just that through Section 1031 of the U.S. Internal Revenue Code – otherwise known as the 1031 Exchange. We are going to do our best to explain a 1031 Exchange, but you can find a description of 1031 exchange for dummies on the IREXA website if you need further details.
“Exchange” a Business or Investment Property
By “Exchanging” business or investment property for another of “like kind”, the IRS allows you to defer the payment of tax liabilities due on gains including Capital Gains and the Recapture of Depreciation. Often times, this amounts to a significant amount of money. By deferring payment of these taxes, you can essentially trade up in value the property you exchange into, thereby not only generating a profit on that sum, but also by leveraging those deferred taxes through financing. If you are able to defer payments, it’s still essential to keep track of receipts and payments just in case the IRS wants to see them. To ensure all financial documentation is in order, this software comes in very useful as it can organize any and all financial records, such as receipts.
While the taxes are still due, they are deferred until such time as you sell the property and elect to receive the gains through an outright sale. However, there are creative mechanisms in which the original amount due is either reduced or eliminated. If you have exchanged a property through a qualified 1031 Exchange, then pass away and bequeath the asset to an heir, the basis in that property is stepped up to the current market value. The previously deferred tax liability may not be eliminated in its entirety but will likely be reduced. Also, it is possible to exchange into a primary residence or vacation home over the course of time by placing the property into service as a rental property, then after a specific amount of time, convert to your primary residence. The subsequent tax implications on the sale of that property would be treated as your primary residence customarily is – depending upon your income, you might not have any tax liability.
Follow the Rules for Beneficial Tax Treatment
However, just because the IRS allows the deferral of these taxes does not mean that they like letting you use “their money”. As such, they have no leniency whatsoever if you do not follow the proper procedures, filings, and/or miss a key date or timeline, so please ensure you consult with a qualified Real Estate Broker, Accountant, and Estate Planning Attorney, which you can find out more about here.
Often confused is the term “Like-Kind”. That does not mean that if you sell a piece of land you must exchange into another piece of Land to qualify. On the contrary, you can exchange a piece of vacant land for a retail building, a multi-family housing project, etc. Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home, does not qualify for like-kind exchange treatment.
Another, frequently overlooked technicality in performing an exchange is how the property to be relinquished is held in title. If your property is held in an LLC, while you may own a portion of that LLC, you don’t actually own a portion of the property, the LLC does. In point of fact, you own a piece of the entity that owns the property. As such, if you intend to sell the property owned by that LLC, unless all partners who share ownership in the LLC elect to collectively exchange the proceeds, you would not be able exchange your own individual proceeds. One way to avoid this issue is to have individually owned LLC’s purchase a property as Tenants in Common (TIC). With this approach, each individual LLC would own an undivided, fractional interest in the actual property itself. Then upon a disposition of a property partnership, each partner would be free to do with the proceeds as they wish.
Alternatively, if you want to use your property to generate truly tax-free money and still want to own that property, you can refinance (assuming the property enjoys enough equity) then use the proceeds to purchase another property. With interest rates being as low as they are, this may be a good strategy to accelerate the growth of your real estate portfolio.
With creative financing structures, the ability to add value and receive beneficial tax treatment, real estate can be a powerful investment vehicle.
