Investors have questions about the future of 1031 exchanges every year. Politicians have long disagreed about the option to use a 1031 exchange to postpone capital gains. The answer to the question of whether this real estate investing tool has recently undergone alterations is no. Instead, investors all around the country are becoming more interested in 1031 exchanges, and new queries have arisen. The most frequent queries from today's curious investors are shown below.
What occurs when a property used in a 1031 exchange is sold?
An investor can transfer one investment property (the "relinquished property") for another (the "replacement property") through a 1031 exchange while deferring the capital gains taxes they would have to pay at the time of sale of the "relinquished property." The Internal Revenue Service (IRS) asserts that the two properties must be of "like-kind," which is defined as any property held for trade, business, or investment purposes under Section 1031 of the Internal Revenue Code.
Unrealized capital gains explained
Unrealized capital gains are gains achieved on an asset that hasn't yet been sold, according to investors and real estate experts. Unrealized capital gains are not subject to tax. In contrast, these gains only exist on paper. Taxes on capital gains are only due when an investor sells the asset.
When can a real estate investor use a 1031 exchange?
Anytime properties are swapped, a 1031 exchange may be employed as long as the new properties are of like-kind according to the IRS. Commercial assets, such as apartment buildings, hotels, and motels, retail assets and single-tenant retail properties, offices and industrial complexes, farms and ranches, and undeveloped land are examples of properties that are frequently traded in a 1031 exchange. Investments in Delaware Statutory Trusts (DSTs) and residential properties held for investment reasons are additional transactions that qualify as like-kind exchanges.
Can a shareholder avoid capital gains by purchasing a second home?
Property owners frequently inquire about their ability to use a 1031 exchange to sell one home and buy another. Sadly, the response is no. Primary residences and second houses are not eligible for a 1031 exchange, according to the IRS; only residential properties held for investment purposes for at least a year are.
Can a shareholder withdraw money from a 1031 exchange?
The entire worth of the property that was given up, including any investor ownership and debt owed on the asset, must be replaced in order for capital gains to be postponed. As a result, if an investor sells a $1 million asset that is 50% leveraged, the investor will need to buy a $1 million replacement property and either use personal funds or leverage a loan for the remaining $500,000 in the transaction. Any money withdrawn from the transaction is subject to taxes.
But there are exceptions to every rule. Investing in a DST is one exception. A legally accepted real estate investment trust that enables investors to purchase fractional ownership interests is known as a Delaware Statutory Trust. Investors can choose how much money to put into a DST and how much debt they want the DST sponsor to attach to them when trading into a DST. A property owner could profit financially from this investment by selling the property.
How do 1031 exchanges operate?
Investors are obligated to adhere to the IRS's stringent timeframe for a 1031 exchange. Taxes are typically required on the property that has been given up when a 1031 deadline is missed.
When the sold property closes, a 1031 exchange's time frame begins. The owner of the property has 180 days to close and 45 days to find replacement properties. One of three requirements outlined by the IRS must be met by the replacement properties.
- The seller may designate up to three properties, of any value, with an intention to acquire at least one of them.
- The seller may name other properties as long as the total value does not exceed 200% of the market value of the property being given up.
- The seller is free to identify any number of properties as long as they are all purchased for at least 95% of their market worth.
Do I require a third party to complete a Section 1031 exchange?
Yes! The involvement of a qualified intermediary (QI) or exchange facilitator is required by the IRS for 1031 exchanges. All revenues from the sale of the property that was given up are held by the QI, who will disburse them towards the purchase of replacement homes. The sale will not be eligible for a 1031 exchange if funds are retained with the seller or any other person that is not a QI, and the seller will be liable for paying capital gains if this occurs.
How does a 1031 exchange operate when there is seller financing?
Although it is legal to employ seller financing in a 1031 exchange, it is not frequently done.
However, this does not exclude them from IRC section 1031, which specifies that an investor must replace the total value of the relinquished property. Seller financing limits the immediate capital available to an exchanger. As a result, while extending seller financing, an investor must specify how they plan to buy their replacement homes. The easiest fix is to provide short-term funding.
However, most buyers' issues are not resolved by this. Instead, to raise the money for the exchange, the exchanger can cooperate with a qualified intermediary (QI) to sell the promissory note they obtained from the buyer. The note can be bought by the exchanger or sold to the lender or another party. Regardless of the choice made, all money must be transferred to the QI by the end of the 180-day period in order to keep the proceeds from being taxable. When money is available, the investor can exchange it for a specific like-kind property.
Can an investor still submit a 1031 exchange after a property closing?
No, since every penny from the sale of the property must be deposited with a QI, a seller cannot submit a 1031 exchange after the closing. Therefore, the proceeds cannot be allocated effectively for a 1031 exchange if the exchange is not preplanned. Before selling their property, investors interested in a 1031 exchange should choose a QI.
If investors reinvest, may they avoid paying capital gains tax?
Property owners can postpone capital gains through a 1031 exchange as long as they reinvest according to the IRS's guidelines. Reinvestment enables investors to take advantage of the many advantages a 1031 exchange has to offer, including portfolio diversification and capital gains deferral. Reinvestment through a 1031 exchange also resets the investment's depreciation schedule, giving owners access to further tax benefits.
What are the most popular real estate investment markets for 2022?
Depending on an investor's investment plan, they might choose the hottest real estate markets. Are they risk-averse and primarily interested in stable assets on primary markets? A value-add asset, a secondary market, or a tertiary market are some other options if they are willing to take on some risk in exchange for larger profits.
Contact a skilled 1031 exchange consultant to better understand which asset and market are appropriate for you. The Perch Wealth team can help you through the process and connect you to properties that are 1031 qualified and fit with your financial and investing goals.
Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. 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.
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 is no guarantee that any strategy will be successful or achieve investment objectives;
- Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
- Change of tax status – 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;
- Potential for foreclosure – All financed real estate investments have potential for foreclosure;
- Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- Reduction or Elimination of Monthly Cash Flow Distributions – 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;
- Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits