A 1031 exchange, alternatively known as a “Capital Gains Deferment” exchange, is a tax-deferred exchange where an owner of a real estate investment property (investor) can substitute one property for another. Although most real estate investors are familiar with the term, many do not understand the intricacies of Section 1031 of the United States Internal Revenue Code or the advanced 1031 strategies and tax benefits available to them.
The real estate attorneys at Mekhtiyev Law can navigate their clients through the real estate laws and how they can be used for the benefit of the clients by maximizing the taxable gains when selling the property. We can help you determine whether you are eligible for a 1031 exchange, the kind of property and ownership that qualifies and assist you in facilitating a successful 1031 exchange.
Understanding the Basics of 1031 Exchange
A 1031 exchange allows you to exchange investment, trade, or business real estate property with a “like-kind” property and to delay the tax on capital gains.
To be eligible for 1031 and deferred capital gains tax, the exchanger needs to assign the sales proceeds from the relinquished property (the property that is to be replaced) to a qualified third-party intermediary who will safeguard the exchange. If the exchanger gets possession of the proceeds, then the tax benefits under the 1031 exchange are forfeited.
45-day rule: Once the relinquished property has been sold, the exchanger has 45 days to inform the intermediary of the potential replacement properties. These are the only properties that are eligible for the exchange.
180–day rule: The exchanger must close on the replacement propertie(s) within 180 days after the relinquished property has been sold or the exchanger’s tax return date for the fiscal year during which the property was sold.
Eligibility for Investment Properties
Investment property is any property that is held for use in investment, trade, or business. Your primary home or secondary home is not qualified for 1031 exchange unless the property was rented to a third party for at least two years during the period of ownership. All the properties exchanged must be located in the United States. The exchanger can sell in one state and purchase in another state.
Examples of like-kind properties that can be exchanged include single-family homes, apartment buildings, rental apartments, office buildings, duplexes, warehouses, utility easements, farms, vacant land, tenant-in-common interests, etc.
Real estate and other items that are not considered investment property and hence not subjected to the 1031 exchange are interests in a partnership, property held for resale, stock in trade, bonds, securities and debt, inventory, and certificate of beneficial interests or trust. However, shares in co-ops can be considered an investment property.
Identifying Like-Kind Properties
The “three property rule” allows an exchanger to identify three like-kind properties, irrespective of value, as replacement property.
The “200% rule” is another property identification rule under which the exchanger can identify any number of replacement properties on the condition that their total value does not exceed 200% of the value of the relinquished property.
Boots in Real Estate
Boots are the taxable cash that is realized in an exchange or tax generated from the difference between the exchange value of the replacement property and relinquished property.
A boot is also a property received by the taxpayer during the exchange, which is not considered like-kind property. If the exchanger does not identify a replacement property with an equal or larger amount of debt, they are relieved of a debt obligation known as a mortgage boot. This debt reduction is considered a benefit to the exchanger; hence, it is taxable unless the exchange adds the cash difference to the replacement property purchase.
Tax Loopholes for Investors
Like-kind exchanges are one of the best tax loopholes for investors. For example, if you have a property that was purchased for $200,000 and increased in value to $350,000, you will be responsible to pay capital gains taxes on a gain of $150,000 when the property is sold. If you exchange it for a replacement property worth $200,000, the $150,000 gain will be taxable.
So you can only take advantage of the tax benefits when you exchange one property for another. Below are some of the guidelines that you need to be adhered to:
- The exchange must be of like-kind. A qualified real estate attorney can help you navigate the statutory rules here.
- If the replacement property is identified and the owner wants to acquire your property, the exchange between the relinquished and replaced property must be simultaneous.
- If the replacement property has not been identified at the time of sale, you can sell your relinquished property and acquire the replacement property within 180 days of selling it. The sales proceed must be held by a qualified intermediary until such time when it can be used to purchase a replacement property.
- Once your relinquished property has been sold, you have a 45-day period during which you need to identify the replacement property you want to acquire. You will then get an additional 135 days to close on the replacement property.
With a 1031 exchange, you can avoid paying capital gains taxes and paying a higher tax rate on depreciation capture on the property indefinitely. By exchanging with a higher-value property, you can also benefit from an additional depreciation deduction, which can increase your income after tax. We are not tax professionals, and each client should consult with their own tax professional for their specific financial situation.
By following the 1031 exchange rule every time you sell your property and acquire a replacement property, your estate will escape all capital gain taxes when you die.
Benefits of 1031 Exchange
- Saving large sums of money on taxes
- Avoid paying high taxes when your property isn’t yielding ROI yet
- Help you diversify your investment portfolio
- Allow you to transfer investments to a more beneficial location
- Help with estate planning
- Reducing your responsibilities/obligations before retirement
Keep in mind that the 1031 exchange can make your investments more complicated. There are several requirements that must be followed to benefit from this code. If you disregard this and do not fulfill all of them, it can result in massive tax bills that will completely offset all the benefits you hope to gain from your investments.
These are the reasons why you need to hire an experienced real estate attorney for a 1031 exchange. This can help assure you are following the tax codes closely and aren’t going to get any unwanted surprises once the exchange is scheduled to close.
Mekhtiyev Law Can Help Handle 1031 Exchanges
At Mekhtiyev Law, our real estate attorneys can handle all advanced 1031 exchange structures and strategies, including:
- Simultaneous exchanges
- Delayed exchanges
- Reverse exchanges
- Drop and Swap and Swap and Drop exchanges
- Split-off exchanges
- Improvement/Reverse exchanges
- Dissolution of partnerships after an exchange
- Reverse and forward exchanges
At Mekhtiyev Law, we represent buyers by negotiating sales contracts with the seller’s attorney and vice versa and ensure smooth cooperation between the seller/purchaser and our client and the qualified intermediary during the 1031 exchange.
We also represent sellers, draft a sale contract, and ensure smooth negotiation with the buyer’s attorney. We help ensure the buyer’s cooperation and assign the seller’s contractual rights and responsibilities to a qualified intermediary.
We can also help you choose an experienced and bonded qualified intermediary for your 1031 exchange.
If you are looking to exchange your properties through a 1031 exchange or just find out more information regarding this process, the attorneys at Mekhtiyev Law can help you. Reach out to us today by visiting https://mekhtiyevlaw.com/ or calling (212)203-6974.
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