The general calculation across the US is that 1/3 of your total gain goes to pay taxes. However, you can utilize the saved, or deferred taxes, to buy more property and put your gain to work for you.
It may seem like a daunting task, but it is not that complicated as long as you follow the rules. A 1031 Exchange account must be opened before the close of escrow on the property being relinquished. The exchanger will help you manage the disbursement funds, write a replacement property letter identifying qualifying potential investments and work diligently to manage parameters and deadlines within your timeframe.
Who qualifies to go into a 1031 exchange?
All taxpayers who own an interest in a building is who does the exchange. If it is in the name of the LLC, all partners have to go into the exchange.
Why enter into a 1031 exchange?
Longtime ownership issues can arise, sparking an interest in entering into an exchange, such as relief of a management burden, exchange from a fully depreciated property to a higher value property after 27½ years, changing demographics, or simply seeking diversification of a portfolio.
The number one reason for doing a 1031 exchange is the deferral of taxes, which on average is approximately 33% without factoring in debt.
The tax depends on what you sell. If you sell a primary residence, you can avoid paying a hefty tax using the homeowner exemption, or Section 121, essentially $250K for single and $500K for married couples. The owner must have resided in the property for two of the last 5 years.
When you are done investing over your career, you finally pay your taxes. The general idea behind 1031 exchanges is that you defer, defer again and then, when you die, your tax liability dies with you. Your heirs receive the property with a step up in basis. For example, if you buy a property at $100,000 and value at death is worth $5M, then the kids would have no gain until after you pass, and the property begins to appreciate again.
If you are miserable managing an investment property, there is a deferable tax solution called a Delaware Statutory Trust . The DST in summary is a holding and management of investment property by a group of owners with a fractional interest as individual owners within a trust, allowing some investors the benefit of diversification in cash flow investments.
You can combine a 1031 and a Section 121 on a 2-unit building. For example, if you own a home with an ADU (Additional Dwelling Unit) that you have rented, you can take a Section 121, or $500,000 avoidance, and do a 1031 exchange with the balance of the gain for the portion of the property that you have been renting out.
Alternatively, if you buy a rental property, after a period of approximately 2 years, you can eventually use it yourself. The IRS does not exclude this eventuality, however, your intent to use a property as an investment must be duly documented.
- Property is held for productive use in trade, business, or investment, including the Delaware Statutory Trust.
- Like kind
- Foreign properties are not like kind, both sold and replacement properties must be located in the United States
- Quick flips are not like kind
- Time – the property should be held at least 1, better yet 2 years.
If you buy a property and build and develop for resale, you are making an long term investment for income. However, a quick flip for gain is not considered acceptable as a 1031 exchange.
It is very important to save and report on all your income for purposes of demonstrating to the IRS that your property is generating income.
You can reinvest equal or greater value (1M-1M+) and use all your cash for down-payment, get another loan or contribute cash. You can get a debt on the old property, take cash and contribute as a down payment to the new property.
If you reinvest from 1M to 950K, you can trade down and only pay taxes on the 50K difference.
You can also buy 2 properties from the sale of one property or you can sell two properties and buy one.
How much time to I have to close on a new property?
Once a sale is closed on a property, a 1031 exchange property replacement must be identified within 45 days and the purchase executed by the 180th day after the close of escrow on the relinquished property.
Identification of all replacement property (or properties) must be unambiguous and presented in writing by the 45th day after COE. The first rule of thumb is three properties, regardless of price, can be identified anywhere in the United States. The 200% rule allows for more than 3 properties to be identified, however the combined value of all the properties must be no more than 200% of the sold property.
In May of 2020, a global pandemic set into motion a stay on exchange time limitations, which is atypical of the IRS, however, the circumstances led them to allow for the following extensions:
COVID Guidelines for 1031 extensions:
- Anyone that sold relinquished property and their 45-day deadline falls between April 1st and July 15th.
- Anyone that sold relinquished property and their 180-day deadline falls between April 1st and July 15th.
What is the Extension?
- The 45-day deadline has been extended to July 15th, 2020.
- The 180-day deadline has been extended to July 15th, 2020.
- Investor Ian sold his property on March 1st. His day 45 deadline of 4/15 is now extended to 7/15.
- Taxpayer Megan sold her property on October 4, 2019. Her day 180 of 4/3/2020 is now extended to 7/15/2020. She does not have an extension for her day 45.
Just to clarify, the requirement for reinvestment in order to defer a tax liability on the sale of investment property, would be to reinvest all the cash generated as a result of the sale of the property; and, the replacement property must be equal or greater in value than the relinquished property.
Some taxpayers opt to do a partial exchange. Other types of exchanges are a simultaneous, delayed, construction/improvement or a reverse exchange. All of these are possible, resulting in a partial deferment of a tax consequence or tighter requirements in the event of a reverse exchange.
In all cases, an asset exchange expert is required to broker the exchange and the advice of a tax accountant or attorney is always recommended to ensure adherence to the tax code.
Working as a team to navigate the intricacy and time sensitive limitations to this marvelous mechanism to defer taxes, working closely with an exchanger resource for all 1031 Exchange matters is imperative. Please don’t hesitate to contact me to schedule a consultation so that I might answer any questions you may have or for any information about the 1031 Exchange process.
If you would like more information and my assisting you in trouble shooting a 1031 for your current situation, it would be a pleasure to help you. Please contact me at (310) 803 6854 or find more information on my website.
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