When a real estate investor sells real estate, a capital gains tax is recognized, along with a tax on deprecation recapture. The regular capital gains tax, deprecation recapture, and any applicable state tax can often result in a tax liability in the 20% to 25% range for the sale of real estate. (If the real estate has been held for less than 12 months, all of the gains will be taxed at much higher short term capital gains rates.)
Enter Section 1031 Exchange
A Section 1031 Exchange, named for the applicable section of the Internal Revenue Code (also known as a Starker Exchange, Tax-Free Exchange, or Like-Kind exchange), which allows an investor to defer all tax on the sale of real estate if the real estate is replaced with other real estates according to a detailed set of rules.
With a Section 1031 Exchange, the replacement property must be identified within 45 days of the sale of the relinquished property. Just like pretty much everything else in our lives, the Section 1031 Exchange has outlined some requirements that need to be upheld if pursuing the exchange.
- The replacement property must be purchased within 180 days of the sale of the relinquished property.
- The replacement property must have a purchase price at least as great as the relinquished property, otherwise, some tax will be recognized.
- All of the cash proceeds from the sale of the relinquished property, less any debt repayment and expenses of the sale, must be reinvested in the replacement property.
- All of the cash proceeds from the sale of the relinquished property must be held by a Qualified Intermediary, which is a person or institution with whom the investor has not recently conducted other business. The investor must not have any access to the cash while it is being held.
- The titleholder of the relinquished property must be the same as the purchaser of the replacement property.
- The sale or purchase of a partnership interest does not qualify for a Section 1031 exchange, except under a few limited sets of circumstances.
- The relinquished property cannot have been classified as inventory, such as condominiums built by the investor, or lots in a subdivision that was subdivided by the investor.
Recognizing All Strategies
If these rules are followed, real estate investors can sell current real estate holdings and replace them with other properties. A Section 1031 transaction is an excellent way for a retiring real estate investor to convert actively managed properties into passive properties, such as triple net leased properties. If you think that a Section 1031 Exchange isn’t quite what you’re looking for, it might be helpful to explore other options.
As we know, a 1031 exchange is where one property is swapped for another similar property. Although this sounds great, this unlikely. Fear not! This is quite common which means that most exchanges are delayed, three-party, or Starker Exchanges. For some of these strategies, you may need a middle man to regulate the swap for you and oversee potential problems.
Overall a Section 1031 Exchange can be ideal for real estate investors. It’s always important to do your research before deciding on a specific strategy that may impact your investments. The best part about real estate investing is the many options that you have at your fingertips for wealth building. It’s always a good idea to branch out and decide what strategy is best for you!