In its simplest terms, a 1031 or a 1031 exchange is a swap of one asset for another.
Unlike a sale, which is a swap for cash, a 1031 is a ‘"like-kind exchange" which is also known as a Starker. The beauty of these exchanges is that they limit the amount of tax due. This means that under the eyes of the IRS, you will not recognize any capital gains from the transaction. As you can see, this can be a powerful tool to defer taxes as you can roll the gains from one investment into another. This can continue until you sell the final asset.
However, 1031s are not a panacea. Special rules are used to determine eligibility and the entire process needs to managed to ensure that "depreciation recapture" does not occur. When this happens, gains are taxed as ordinary income at a much higher rate. While this can be avoided, there are situations where it might not apply. One example would be the swap of improved land and the accompanying structures for unimproved land. In this instance, the depreciation claimed from the previous parcel would be taxed as ordinary income.
As such, here are a few things you need to know about 1031 exchanges:
1. Exchanges Are Primarily for Corporate Use
As the exchange only applies to commercial, industrial or investment assets, you cannot use this mechanism to swap your home (unless it is owned by a corporation) for another house.
2. However, There Are Loopholes
The proceeds of the sale must be re-invested in a like kind asset within 180 days of the sale. Restrictions are imposed on the number of properties that can be identified as potential Replacement Properties. More than one potential replacement property can be identified as long as you satisfy one of these rules:
1. The Three-Property Rule - Up to three properties regardless of their market values. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
2. The 200% Rule - Any number of properties as long as the aggregate fair market value of all replacement properties does not exceed 200% of the aggregate Fair Market Value (FMV) of all of the relinquished properties as of the initial transfer date. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
3. The 95% Rule - Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified. In other words, 95% (or all) of the properties identified must be purchased or the entire exchange is invalid.
3. What Is ‘Like-Kind’?
Well, this is something that is often misunderstood. ‘Like-Kind’ applies to the use of the property from an investment standpoint and not what the property is or does. As such, you can exchange a cattle ranch for a strip mall or one business for another. While the definition is open to interpretation, the devil is in the details.
4. No ‘Players to Be Named Later’
1031 exchanges are not baseball trades; there are no players to be named later and the timing of the transaction must be strictly observed. As such, a replacement property must be named in writing within 45-days of the transaction. If this does not happen then the entire transaction will not be eligible for the 1031 exemption.
However, up to three properties can be named as the replacement property if the fair market value of the named properties is less than 200% of the fair market value of all properties exchanged. Leave it to the IRS to complicate the process.
Once the properties are agreed to, you will have 135-days to close on the replacement properties. All told you have 6-months to finalize the swap, if not, then everything is taxable.
4. Mortgages and Debt
This is one of the biggest issues with 1031 exchanges, as many people fail to take into consideration any underlying loans or liens on the assets. Often, what happens is a "boot," which is taxable. A boot mortgages assets are swapped, but the mortgage balances are not the same. For example, Property A has a $350,000 mortgage, while Property B has a $325,000 mortgage. In this scenario, the boot would be $25,000. This amount will be taxed.
If you are interested to learn more about 1031 exchanges and the 1031 exchanges utilizing the Delaware Statutory Trust,known as the DST (DST investments can only be invested in by accredited investors), then you can check out several DST replacement properties here which will give you more information about the types of properties available. Remember 1031 exchanges are relatively straightforward, but you should always get the advice of a tax accountant or attorney before finalizing a deal. This will save you headaches and dollars down the road.
The acquisition or sale of a Delaware Statutory Trust (DST) for the purpose of a tax-deferred 1031 exchange qualifies for treatment under section 1031 of the Internal Revenue Code ("1031 Exchange"). Investors will be able to sell the existing investment property or beneficial interest in a DST and complete a 1031 exchange into another "like-kind" investment property or beneficial interest in a new DST.
There are risks associated with investing in Delaware Statutory Trust (DST) and real estate investment properties including, but not limited to, loss of entire principal, declining market value, tenant vacancies and illiquidity. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million dollars exclusive of primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney.)
The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments, and is not meant to be interpreted as tax or legal advice. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. Please speak with your legal and tax advisors for guidance regarding your particular situation.
Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC, an SEC registered investment adviser. Insurance offered through Concorde Insurance Agency, Inc. Fortitude Investment Group is independent of CIS, CAM and CIA.
Source: Fortitude Investment Group LLC