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Investing in real estate has been a long time tradition and a part of the American dream for a long time. The 1031 Exchange lessen the burden that investing brings of either making you or breaking you. With the many tax regulations and rules that go along with buying and selling properties, IRC section 1031 can be an investor’s golden key to significant cash flow and net worth increases that can be handed down through generations.
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What is a 1031 Exchange?
Very plainly, a 1031 Exchange, also known as a Like-Kind Exchange or a Stark Exchange, can be found in the tax codes under “Like-Kind Exchanges” Under IRC Code Section 1031. This type of exchange has been around since the 1920s and remained unchanged until 1984. Time limits were then implemented into the exchange allowing the closings on the exchange properties to be done on separate days rather than one long all day process.
A 1031 Exchange allows investors to sell a property for a capital gain and if the investor puts that gain into a like-kind property, then the taxes on that gain are deferred. When you meet certain qualifications in the code, as investors you can avoid paying depreciation, recapture and capital gain taxes. When you complete the sale of your relinquished property and replace it with another, your economic status has not changed, but the benefits of your investment could increase. Because an investors financial situation remains the same; the Exchange was created. It was considered that asking a seller to pay taxes on something that was never received would not be a fair deal.
What is a Like-Kind Property?
Like-kind properties have a broad definition within the code. A personal residential property does not qualify for the exchange. However; property that is going to be used as an investment can be. “Like-kind” does not mean the properties must be identical, they just have to be utilized for the same purpose. An apartment complex can be exchanged for raw land or a rental home exchanged for a strip mall; these examples are considered like-kind because they are all investments. An investor can also trade one property for several or several for one.
Time Limits in the Exchange
Before 1984, exchanges were usually done all in the same day, one property closed and the other right after. This process often took an investor all day. In 1979 the case Starker vs. the United States changed the code requirements and set in motion a change in the 1984 tax reform. Exchanges no longer had to be done simultaneously and a time limit was implemented stating that the exchange replacement property must be identified within 45 days of the transfer of the relinquished property. The full transaction must be completed within 180 days.
Advantages and Draw Backs of 1031 Exchanges
Like anything else, the Like-Kind exchange has its benefits and drawbacks. The Huffington Post outlines some of the advantages as being:
- Defers taxes, gives leverage and increases cash flow: Allowing you to sell and reinvest without paying taxes on the profit from the sale and also increases your purchasing power for the replacement property or several properties giving a higher investment benefit.
- You can get relief from the management of high maintenance properties: You can take a problem property and exchange it for a better more profitable property.
- Increases cash flow and net worth while leaving a legacy: A great wealth builder investors can increase cash flow and net worth with each 1031 transaction. In some cases, this investment can be passed down after death giving future generations a stepping stone to a greater net worth or sell the investments.
There are drawbacks of a 1031 exchange because of the many rules and regulations set by the IRS are meant to reward investors for putting back into the economy. When these rules are followed, then no income will be recognized, but if not it could cause an investor to have to pay taxes or penalties.
- Meeting the regulations can be challenging: such as finding a like-kind property within 45 days after the sale of the relinquished property
- Losses can’t be Recognized: Just as taxes are deferred, losses are as well, making it hard to offset large profits.
Who qualifies for the Section 1031 exchange?
The Different Structures of the Exchange
According to the IRS Newsroom, there are several different structures in the Like-Kind Exchange
- The simultaneous exchange is the most simple. One property is swapped for another.
- The Deferred exchanges are allowed for flexibility but are a little more complicated. This exchange allows you to sell one property and then acquire another within the 45-day time limit. Because of the timing and complexity of this exchange investors are encouraged to seek help from an exchange facilitator who can make certain all the procedures are followed.
- A reverse exchange is more complex than a deferred. In this case, a replacement property is found and parked with a titleholder for no more than 180 days at which time the investor must dispose of the relinquished property to procure the replacement.
For the investor, 1031 Exchanges are something worth looking into, however; keep in mind that even though paying your taxes on a relinquished property are waived, this doesn’t mean you get off tax-free. The taxes are deferred, meaning that should you ever cash out on any of your investments, you will be paying taxes on that gain. But until you are ready to get out of the property investment business, a 1031 is one way to build wealth and long term security.