We all know and see it.
Real estate has become so relevant today to the global market as demands continue to spike. And when there is an increase in needs, business owners come in.
These types of facilities are those that generate profit, either from rental income or capital gain. These commercial properties may be in the form of medical centers, office buildings, malls, hotels, multifamily housing buildings, retail stores, warehouses, garages, and farmland. Almost any infrastructure, basically. Even a residential property with more than a few units can be classified as a commercial property in many states.
But, hitting success in the real estate market is not just a walk in a park.
A commercial property with high value can give its owners a hard time. As much as the homeowners would like to sell their commercial properties, they can't hide from the fear of getting thumped with a substantial capital gains tax bill. This imposed tax sets aside the historical cost of the property; it solely considers the current market value of the property.
However, despite this seemingly harsh reality, the knowledgeable real estate professionals, real estate investors, and people inclined to this business know one thing that can defer one from paying capital gains taxes.
If you're thinking and afraid to be caught by the authorities, worry not because this is perfectly legal. The investment method that I am about to share with you is called the 1031 exchange. And I'm telling you, it's an interesting one.
What is the 1031 Market Exchange?
The term 1031 came from section 1031 of the International Revenue Service. It is also known as the like-kind exchange or the Starker exchange.
In the general sense, it functions by making it more real for the investors or sellers to accede from paying capital gains taxes on a particular commercial property upon its sale. How? "As long as another, "like-kind" property bought with the profit from the sale of the investment property," the author Terin Miller briefly explained. (Like-kind is a kind of swap of one commercial property to another for the capital gains taxes deferred).
In a 1031 market exchange, an owner of a particular property can swap to another investment property of a like-kind. However, for this to work, the other property owner must be willing to buy your property in exchange.
What's more impressive about this exchange method is, although most of the trades are taxable as sales, if the trade-off you are going to meet meets the requirements under 1031, you will be provided with either limited tax or no tax (!) due in the time of exchange. Say bye to fear!
Key Points
Before we dig in any further, whether you're already an investor or neophyte in this industry, there are a few points/ reminders you should understand. Take note if you must:
- 1031 sale is a kind of swap of commercial properties used for investment purposes or in the business of any kind.
- The commercial properties being exchanged must meet the International Revenue Service guidelines for the capital gains taxes to be deferred.
- If the 1031 market exchange is being used correctly, there are no actual limitations on how many times you utilize the method.
- The 1031 rules can be applied even to a former primary residence under specific conditions.
Now, if a taxpayer who is selling his or her investment property would be able to find and buy another residential within the specified time limit, he/ she is no longer subject or obliged to pay for the taxes on the first disposal. The person would only be spending their taxes upon selling or removing their second investment property unless otherwise, a "like-kind" exchange is done. In this case, the payment of taxes will be deferred.
Additionally, there are also important considerations that a taxpayer must always keep in mind with a like-kind exchange for him or her to be sure that they are not liable to pay taxes upon selling the first asset.
First, the support that is being sold is not supposed to be personal property. The property must be an investment property. Simple as that.
The second point you should consider is that the asset that they will be purchasing with the proceeds must be the same as the one that was sold.
Lastly, the taxpayer must identify the particular property or asset that they will be buying in like-kind exchange within 45 days after the sale. You see, the assets coming from the previous sale must only be used to purchase an investment property or acquisition within 180 days after the sale of the first property. (Don't worry, the 45-day rule and the 185-day rule will be further discussed in the succeeding paragraph. So, keep on reading)
The Special Rule for Depreciable Property
When depreciable property is subject to exchange, there are special rules that entail it. Why? Because a discussion of this type can trigger a kind of profit known as depreciation recapture, which is taxed as ordinary income.
Generally speaking, if you swap one commercial property for another commercial property, you can actually avoid this recapture. On the one hand, the improved commercial land with a depreciable building will be recaptured as ordinary income.
Sounds complicated? Well, it is in a more profound sense. You can consider asking for a professional for this matter for a straighter comprehension.
Delayed Exchanges and Timing Rules
You've probably already realized at this point that exchange involves two people doing their swap of one property to another property. However, the chances of finding the same person who has the same stuff like you and, at the same time, the exact property that you want are small. Because of that, the majority of the exchanges are delayed, three-party, or Starker exchanges.
Now, if you find yourself in a delayed situation, you need an intermediary. The middleman is responsible for holding your money after you sell your property. While on it, he or she also uses the money to buy a specific replacement property on your behalf. This type of three-party exchange is also treated as a swap. (U.S. Congress, www.congress.gov).
In a delayed business, you must observe two essential timing rules: the 45-day rule and the 180-day rule.
45-Day Rule
This timing rule is related to the designation of a replacement property. Once your property is being sold, the middleman or the intermediary will be the one to receive the money. As the owner, you cannot accept the money because it will make a fuss over the 1031 treatment.
Also, within 45 days from the day your property was sold, you are responsible for designating the replacement property in writing to your middleman. The letter must specify the stuff that you want to acquire. According to the IRS, you can write three properties as long as you close a deal in any of them. You can write more than three properties as long as these properties go under the specific valuation tests.
180-Day Rule
This type of timing rule in delayed exchange, meanwhile, relates to closing. Within 180 days after your old property was sold, you need to close a deal to a new property.
An important thing to remember: the two periods, as mentioned earlier, are running concurrently. That means that you will start counting when the sale of the property closes. For example, you designated a replacement property precisely after 45 days; then you only have 135 days to complete it.
To tell you the truth, selling a property is sometimes burdensome: when you sell a particular investment property, you also have to pay capital gain tax. Most of the time, the investment you had can cost you more than the property's price when you sell it.
However, if you own particular property, whether it be a rental property or any property that has gained more value from its original price when you purchase it, you could use it to make more money using the 1031 strategy.
After all, it'll be worth it!
1031 Market Exchange Steps
To use the strategy to defer a tax, you will need to buy a property that has a similar value to the one you're selling. For instance, if you sold your property for $5 million that had a $1 million mortgage, you would have to buy a property for the same cases of the amount or more in leverage.
The example mentioned above might sound nonsensical at first glance. But, this can be turned or transformed into our advantageous edge by following these simple steps:
- Sell an investment property or commercial property
- Give your capital gains to your middleman or qualified intermediary
- Find a like-kind property within 45 days
- Negotiate with the other seller of the like-kind property
- Agree on the price of the sale
- Let your middleman or intermediary wire the capital gains to the holder of the title
- Fill out the IRS form
To further deepen your understanding of the steps, let me paint you some examples:
Example No. 1
Mark is a real estate investor. He bought a residential investment property two years ago for $50,000. Mark owns it upright. He gets it appraised and finds its actual value is $100,000. The property will reap a $50,000 gain and around $5,000 capital gains tax if it is sold.
Mark decided to sell the property and purchase a larger property with his capital gains, deferring the capital gains tax on the sale and maybe state taxes, using a 1031 Exchange. First, Mark attempted to market his property for $100,000 with the aid of a real estate agent, knowing it could lead to $50,000 of profit from his initial purchase price. The clock initiates ticking on the 45-day determining process when the title is transferred.
Mark finds a qualified intermediary who holds his capital gains on the sale, almost like an escrow account. Within the 45 days, Mark sends the intermediary a letter listing the properties he identified for the method of 1031 exchange. The list can stretch up to three parties, but only the stuff on that list can be used in a 1031 Exchange.
Once his agent finds a like-kind property within 45 days for $150,000, he will have half a year from the day of the sale to seal on the property. And if the seller agrees to sell it to him for $150,000, Mark will instruct his qualified intermediary to wire $50,000 in capital gains, most often to a known company. The balance of $100,000 cost of the establishment would have to be compensated either by additional equity or debt. Still, the $50,000 in capital gains would be deferred, as would the $5,000 in capital gains tax.
Example No. 2
Lysa wants to sell her commercial property for $5 million. She bought it for $3 million as an investment. Meaning, the sale will generate a 2-million-dollar taxable capital gain.
However, suppose Lysa uses the 1031 exchange strategy. In that case, she can accede her capital gains tax by swapping the commercial property for a like-kind property – another commercial property similar to the one she is selling. However, she only has 45 days to find a like-kind property from the day she sold your property. If she didn't find any like-kind property within the given period, she could face capital gains tax and state capital gains, too.
For Lysa to ensure compliance, she needs to contact a qualified intermediary like an escrow company to make a suitable exchange arrangement. The intermediary is tasked with transferring the property of Lysa to the buyer and moving the replacement to Lysa.
Example No. 3
A couple named Chris and Anna purchased a simple apartment building in Houston nine years ago for $1.5 million. The couple takes out $500,000 of their own money and hands in the mortgage for $1 million.
After several months, the couple's transformed basis in the apartment may show the acquisition price. The purchase cost (such as title) of $10,000, add the expenditures for improvements (such as a new flooring) of $65,000, minus the depreciation of the building over its usage timeline of $400,000. Far from considering deferred capital gains, the property's adjusted tax basis at the sale would be $1.175 million.
The couple chose to sell their property. They hope they could price it at $2.85 million, less closing costs on the relinquished property of about $50,000, summing the total selling standpoint of $2.8 million. Deduct from that the adjusted tax baseline of $1.175 million, and the observed gain on the profit would be $1.625 million.
However, that is not the same from the net cash acquired. Why? Say, the sale price is $2.85 million; diminish about $800,000, which was paid down on the mortgage, the closing costs on the relinquished property and the net cash received from the sale would be $2 million. Yes, there's a lot that needs to be considered, but please bear with me.
After this, the couple is required to compute their tax liability from the gross sale. Assuming a seen gain of $1.625 million on the deal, they'd have to calculate their Equity gains tax on the revenue of about $245,000. Now, consider the federal tax on depreciation of 25%, or $100,000; the state capital gains tax of 12.3%, or $199,875; and the affordable care act surtax of $61,750, resulting in a rate of 37.3%, or $606,625.
With the 1031 Exchange method, the couple can put off their 37.3% obligation in taxes and get all their income from the sale or revenue. Also, they have $2 million in capital ready to reinvest, rather than $1,393,375 ($2 million deducted by the payments made $606,625).
To defer all of their property taxes, the Replacement Property must have a purchase price and mortgage balance equal to or higher than the relinquished establishment placed on the market. It is not mandatory for the investors to place their revenue into the replacement property. Although, they are exercising what is referred to as a partial exchange, and the portion of their revenue that is left is called the "boot" (an element that may face tax charges).
Essentially, any investment property other than your main residence can qualify for an exchange. The IRS distinguishes any investment property as "like-kind." So, they are different.
For such exchange to happen, two or multiple properties from the United States must be present with interests in the replacement property. This way, investors, like you, can participate with their shares on the property.
(Examples were adapted from www.thestreet.com; names were changed)
Indeed, the 1031 Exchange is helpful in terms of deferring capital gains tax. There is also another type of exchange that is similar to 1031 – this is the 1033 Exchange.
IRS 1033 refers to a property that was converted or exchanged involuntarily. The property might be condemned or under the threat of being criticized, stolen, and destroyed. If the property received a "similar or related in service or use," you don't need to report the gain.
Unlike the 1031 Exchange, the 1033 Exchange has no time restriction. In most cases, the 1033 exchange rules are much easier to conform to than those of the 1031 exchange. However, even in almost every aspect of life, there are still limitations with the similarities of both 1031 and 1033 regarding deals and restrictions in acquiring these two exchanges.
From the previous information that we had in this article, we can say that the 1031 Exchange is not intended for personal use. It is supposed to be used only for investment and business property.
However, you might have heard of some taxpayers who used the provisions of 1031 for them to swap one vacation home for another one. Perhaps the 1031 market exchange delayed the process of moving into the home where they wanted to spend the rest of their years after retirement. After some time, they transferred into another property, declared it as their primary residence, and then, in the long run, planned to use the $500,000 capital-gain exclusion.
The said exclusion permits them to sell the primary residence and, united with their next of kin, shield $500,000 in capital gain, as long as they have lived there for two years out of the past five.
But, the U.S. congress with Public Law 108-357, Section 840, has strained up that loophole. The taxpayers can still transform homes intended only for a vacation into rental properties and do 1031 exchanges. For instance, Monica already stopped using her beach house, renting it out for a year and then exchanging it for another kind of property. If Monica happens to get a tenant and conduct herself in a business-like way, she would have probably converted her vacation house to a type of investment property that makes her 1031 exchange run smoothly.
However, if Monica only offered or posted it for rent but did not have an actual tenant due to some circumstances, this is not permissible. Facts and timing will always be the keys. About this matter, the longer the time, the better. Because the more time that passes after Monica converted her private vacation house to a rental property, the higher her advantage is.
It may seem like a basic process, but there are a few more things you should consider: the timing, period, rental agreements, and the likes. All of which contributes to complex investment choices you have to make.
The things that we have discussed and the tips shared throughout this article lead us to conclude that knowledgeable investors of the real estate industry can use the 1031 market exchange to defer the taxes and gain so much wealth. The innumerable complex parts that hide underneath the benefits of this type of change require a mere understanding and help to come from enlisting professionals or agents – not only for the neophytes in this investment industry but also for those who have a lot of experiences.
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