In our last article, we discussed what considerations to be aware of when purchasing a new property with the proceeds of your relinquished property. We also mentioned how you have more options than you think for engaging in purchasing a new property to continue the benefits of owning investment property. So, in this article, we will discuss the 1031 exchange as a potential option to replace your rental income with a new property.
What is a 1031 Exchange?
A 1031 exchange is a tax code provision that allows for tax deferral on investment or business properties and replacing it with a like-kind investment property without incurring immediate capital gains taxes. The exchange only applies to investment and business properties, and the properties being exchanged must be like-kind in the eyes of the IRS. A like-kind property is a real estate asset exchanged for business or investment purposes that have similar nature or character (not its class, grade, or quality)—thus the term “like-kind.”
How to Execute a 1031 Exchange
The proceeds from the sale must be held in escrow by a third party called a qualified intermediary. The investor must identify potential replacement property within 45 days and close escrow within 180 days of selling the first property. The exchange requires a qualified intermediary to hold the funds from the sale of the first property and transfer them to the replacement property. The exchange enables investors to defer taxes and reinvest the proceeds into a new property, which can potentially produce higher returns.
Primary residences, securities, stocks, bonds, partnership interests, and other financial assets are excluded from 1031 exchanges. Remember, only income-producing or business properties qualify. These exchanges can take several forms, including deferred and simultaneous exchanges, and the process can be quite complex. Therefore, working with a reputable, full-service 1031 exchange company is essential to ensure that the exchange is executed correctly.
Is the 1031 Exchange Right for You?
Deferral of capital gains taxes may sound like a great benefit to you, but 1031 exchanges won’t be recognized if you execute the exchange incorrectly, or if the type of property you sell, or purchase, doesn’t fit the criteria for the like-kind status. So, if your real estate decisions are contingent on executing a like-kind exchange, ensure that your properties and timelines are pursuant to the 1031 Exchange rules.
If you’ve reviewed the 1031 exchange law and realized that it won’t work for your real estate investment plan, you may need to go back to the drawing board and revisit your other options, such as keeping your property, downsizing, or utilizing residential property sales tax benefits to help reduce your costs of selling.
So, What Will Your Like-Kind Property Be?
If you’ve determined that a 1031 exchange could work for you, it might mean that you have an investment or income property that you manage yourself and are looking to replace it with a better, more favorable one. If that’s the case, you’ll want to know about an option that may be a great fit for your 1031 Exchange plans. Real estate investors have several tax-deferring strategies available to help them optimize their tax obligations. One strategy is called a Delaware Statutory Trusts (DSTs). DSTs function as an investment vehicle that allows you to be a direct investor in real estate properties (as opposed to an investor in real estate stocks, which doesn’t grant you ownership to any of the properties directly), along with a pool of other investors, while the property management headache is handled by a professional real estate management group. For some, this option can be the best of both worlds. Stay tuned for more on what a DST is and how it could work for you!
An additional strategy is utilizing a self-directed Individual Retirement Account (IRA) or a Solo 401(k) plan, which allows investors to invest in real estate and enjoy tax-deferred growth within the account. This strategy provides flexibility and control over investment decisions while deferring taxes on rental income, capital gains, and dividends. Additionally, real estate professionals may consider utilizing a real estate professional status to offset passive losses against active income. By meeting certain criteria, investors can categorize their real estate activities as a trade or business, enabling them to deduct rental losses against their other sources of income. These tax deferring strategies provide real estate investors with valuable opportunities to manage their tax liabilities effectively and maximize their investment potential.
Because investor situations and objectives vary this information is not intended to indicate suitability for any individual investor.
This is for informational purposes only, does not represent legal or tax advice does not indicate suitability for any particular investor, and does not constitute an offer to purchase or sell investments.
Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.
There are material risks associated with investing in private placements, DST properties and real estate securities including illiquidity, general market conditions, interest rate risks, financing risks, potentially adverse tax consequences, general economic risks, development risks, and potential loss of the entire investment principal.
There are retirement account risks that could diminish investor returns, such as, but not limited to: low interest rates, market volatility, withdrawal timing and sequence of returns risk, government policy uncertainty and increased longevity. Prospective investors should perform their own due diligence carefully and review the “Risk Factors” section of any prospectus, private placement memorandum or offering circular before considering any investment.
Advisory Services are offered through Asset Strategy Advisors, LLC (ASA), a SEC Registered Investment Advisor. Securities offered through registered representatives of Concorde Investment Services, LLC. (CIS), member of FINRA/SIPC. Insurance Services offered through Asset Strategy Financial Group, Inc. (ASFG). ASA, CIS, and ASFG are independent of each other. All research reports from third parties are for informational purposes only.
