Why 1031 Exchange Investments Are Worth a Look
With tax reform nearing final passage in Congress, one of the most underlooked, but potentially overpowering, tax-advantaged investment tools is the 1031 exchange, which was spared major changes in the proposed legislation.
The 1031 exchange, especially when related to real estate investments, is all about "timing and taxes" and the better you manage the two, the more money you can make.
What is a 1031 exchange? By and large, IRS Section 1031 covers "exchanges" or swaps of a specific investable asset (such as real estate) for another. The end game for the taxpayer/investor is to avoid having exchanges listed as taxable sales. But if they're executed within the confines of a 1031 exchange, taxes are either significantly reduced or eliminated altogether.
[See: 7 ETFs to Trade Like a Hedge Fund.]
The primary benefit of 1031 exchanges related to real estate investments is tax deferral, or avoidance of capital gains taxes on the sale of appreciated investment property, says Kevin O'Brian, a certified financial planner at Peak Financial Services, in Northborough, Massachusetts.
"If held inside owner's estate at death, the asset would receive a step-up in cost basis to the market value, as of the date of death," O'Brian says. "Therefore, heirs could avoid capital gains taxes, if sold after inheriting it as well."
Others note that following IRS guidelines on Section 1031 are a must.
"1031 exchanges allow a real estate investor to sell one property that has appreciated in value and not pay capital gains tax so long as the investor buys another property," says David Reiss, a professor at Brooklyn Law School. "This is a powerful tax deferral tool that many sophisticated real estate investors use. It is, however, somewhat complicated to pull off and involves some additional costs and planning so it is not for those looking for a quick and easy way to defer capital gains."
What are the rules for a 1031 exchange? The rules governing 1031 exchanges have to be followed carefully and it makes sense to plan for it with an appropriate team of professional advisors and a reputable 1031 exchange company, Reiss says.
"Generally, the investor needs to sell the property that has appreciated in value; place the proceeds in escrow with an intermediary; and then use those proceeds to buy a replacement property within a certain period of time," he says. "If the investor fails to follow the requirements for the exchange, he or she may be taxed on the full capital gain."
[See: 7 ETFs That Let You Invest With the 'Smart Money'.]
Investors should also be sure to use a 1031 exchange company that meets specific criteria. "Not the least of which is that it's properly insured to protect you in case your funds disappear from escrow," Reiss says. "This has been known to happen."
Some see a 1031 exchange as an IRS-sanctioned way to grow your real estate portfolio by deferring taxes, says Noel Dalmacio, a certified public accountant at Dalmacio Accountancy Corp., in Irvine, California.
But there are plenty of caveats there, too.
"A 1031 exchange allows you to sell a property, reinvest the cash proceeds in a new property and to postpone all the capital gains taxes," Dalmacio says. "If you do it right, you can build your wealth without paying taxes at the end."
The first important factor is that both pieces of real estate exchanged must meet both of two critical criteria -- like-kind property and qualifying property.
"A like-kind property simply means that both real estate properties being exchanged must be of the same type or nature, even in cases where the assets vary in quality or grade," Dalmacio says. "So, exchanges between two pieces of real estate, regardless of their use, would qualify as a like-kind exchange. For example, a single-family residence can be exchanged for a vacant land."
Both of the pieces of real estate must also be classified as qualifying properties, which are properties that are held for either investment reasons or for a specific, productive use in a trade or business. "Personal residence and certain vacation homes do not qualify," he adds.
For the purposes of real estate like-kind property, Dalmacio offers the following examples:
-- Rental property for rental property
-- Land for land
-- Land for rental buildings
-- Improved properties for non-improved properties
-- Office buildings for condominiums
-- Retail stores for apartment buildings
-- Trailer parks for hotels
-- 30-year or greater leasehold for land
-- Tenant-in-common interest in real estate properties for rental buildings
1031 exchange investors must also adhere to the 45-day rule. "Replacement property must be identified within 45 days of the sale of the property you are giving up," Dalmacio says. "There are no extensions allowed."
Time-wise, that's not all -- an 180-day rule is in play as well.
"The property must also be purchased within 180 days of the sale of the property you are giving up or your tax return's due date, including extensions, whichever deadline comes first," Dalmacio says. "Keep in mind that there are no extensions allowed."
[See: 7 of the Best Stocks to Buy for 2018.]
Additionally, under IRS related-party rules, exchanges between related parties will be disqualified by if either the seller or the buyer disposes of the property within two years of the exchange. "The IRS will force you to report the capital gain or loss as of the date of the sale," Dalmacio says.
Related parties can include spouses, siblings, parents, children, or a corporation or partnership in which you own more than 50 percent.
The 1031 exchange offers ample opportunities for real estate investors to keep cash away from Uncle Sam. Talk to a trusted tax professional and see if the IRS 1031 exchange is a tax number that works for you.
Brian O'Connell is a contributing financial writer for U.S. News & World Report. A former Wall Street bond trader and the author of two best-selling books; "The 401k Millionaire" and "CNBC's Creating Wealth", he has 20 years experience covering business news and trends, particularly in the financial, technology, political and career management sectors. His byline has appeared in dozens of top-tier national business publications, including CBS News, Bloomberg, Time, MSN Money, The Wall Street Journal, CNBC, TheStreet.com, Yahoo Finance, CBS Marketwatch, and many more. Visit his web site at: https://brianoco.contently.com/. Or, visit this Amazon.com link for a list/review of some of his book titles. Reach out to him on LinkedIn.
