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 1031 Exchange Rental Property



About 1031 Exchange Rental Property:

Since 1921 investors have been given the opportunity to defer the capital gains tax from the sale of a property by using 1031 exchange.   

Tax Deferred 1031 Exchange allows an owner of real property, the Exchanger, to defer the recognition of a capital gains tax normally recognized on the sale of real property, if the exchanger buys a like kind property of equal or greater value and uses all of its cash equity in the subsequent purchase.  

Like kind property does not mean an office building to be exchanged for another office building or free standing single tenant retail property to be exchanged for another single tenant retail property. There is no requirement that properties be similar in type or class. However, real property must be exchanged for real property. Like-kind propery is defined as property held for productive use in a trade or business, or for investment purposes, that is exchanged for property which is also held for productive use in a trade or business, or for investment purposes. Example, a vacant land which is held for investment purposes can be exchanged for retail property held for business purposes. 

1031 Tax deferred exchange should be done through a qualified intermediary. A Qualified Intermediary is an independent third party to the transaction whose function is to prepare the documents necessary to create the exchange, as well as to act as the independent escrow agent for the exchange funds. 

How much many can be saved through a 1031 Exchange for a next purchase? 

Example: If an investor is selling a shopping center for $1,000,000, and has a net adjusted basis of $500,000, the investor will have a gain of $500,000 upon the sale of the property.  

Current federal capital gains tax is 15% on the amount the property has appreciated in value. The investor will also pay a tax known as depreciation recapture at the rate of 25% for the amount the property has been depreciated during its ownership. In addition, there may be a state or local capital gains tax. 

Many investors multiply the gain by 25% to get a rough estimate as to the amount of tax they might realize if they do not structure the transaction as an exchange. In this example the gain would be approximately $500,000. Accordingly, if we multiply this amount by 25% the estimated capital gains tax if this sale were not structured as an exchange would be $125,000. 


Three methods for 1031 Exchange Rental Property: 


A) Identify three properties of unlimited value (Most Common Method) 

B) Identify an unlimited number of properties whose aggregate fair market values do not exceed 200% of the value of the properties sold in the exchange 

C) Identifies more than three properties and their aggregate fair market value is in excess of 200%, the Exchanger must purchase at least 95% of the value of the properties identified. 


1031 Exchange Rental Property Restrictions: 

1)         Exchanger has 45 days from the date of the sale of the first relinquished property to identify potential replacement property or properties; and a total of 180 days from the original sale date to purchase the replacement property or properties. 

2)         Exchanger must acquire replacement property of equal or greater value, obtain equal or greater debt on the replacement property, reinvest all the net proceeds realized from the sale of the relinquished property, and acquire only like-kind property. 

3)        Exchanger must own the investment property for at least one year before he can use it for 1031 Exchange. 

4)      Exchanger must initiate the 1031 process before the closing, once the closing occurs; it’s too late to utilize the 1031 deferred exchange.

5)         Exchanger may use the vacation house or primary residence for 1031 exchange as long as the property is reported as a rental or business use on the tax returns for two consecutive years. 


Advantage of 1031 Exchange Rental Property:


1) When selling real estate, if you sell and reinvest, you will pay income taxes on the realized gain. However, with 1031 exchange, you will defer the tax gains.


2) You may have management-intense rental properties and would prefer to transfer your equity to ease-of-ownership   single tenant properties (coupon clippers) such as Walgreen Drug Stores, Wal-Mart, Post Offices, 7- Eleven, Office Depot, etc.


3) You may have been holding properties long after their appreciation has topped out. You can start rebuilding your equity by disposing of those investments and acquiring new ones.


4) You may have some non-income producing real estate investments, such as raw land. You could exchange this property for another asset that would not only give you cash flow, but also get you income tax deductions such as depreciation, which you did not have with your raw land.


5) This means that more money is available for acquiring your next investment. It can be regarded as a free loan from the government!


6) You may have owned a leveraged property long enough to have accumulated considerable equity. You now have an opportunity to exchange into a larger asset, and reposition your equity to your benefit or that of your heirs, without paying taxes. We highly recommend using qualified professionals that have experience in 1031 tax-deferred exchanges to guide you and ensure your compliance with government regulations.


7) With proper estate planning you can keep exchanging properties throughout your lifetime. Neither you nor your heirs will ever pay income taxes on the gains. By doing a tax-deferred exchange,you conserve your equity by not having to pay taxes on your net profits.




Disadvantage of 1031 Exchange Rental Property:


1) Exchanger will have a slightly lower depreciation schedule when acquire  new properties. This is because the IRS will look at the new tax basis as being the same as the previous one, less the deferred gain.


2) Exchanger losses on the income tax return cannot be deducted if you exchange property rather than sell it. If you want to take a loss, simply call it a sale, not an exchange.




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