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Venturing into any industry requires one crucial first step – market and industry study. Failure to do the above will spell doom for you and your future investments, especially in an industry notorious for its competitiveness – the real estate industry. As a novice in real estate investing, you may encounter foreign terminologies and concepts associated with the business.
One of such terms is 1031 Exchange. Have you ever heard of it? Do you want to know what the concept entails? This article brings you into the know by highlighting the rules, concepts, and steps involved in a 1031 exchange. Let’s dig in!
What is 1031 Exchange?
With its name coined from Section 1031 of the U.S. Internal Revenue Code (IRC), the 1031 Exchange is a strategy for real estate investing that allows investors to avoid paying taxes on capital gains when they sell properties. It empowers them to reinvest any profit accrued into similar properties of equal or more excellent value within a time limit.
1031 exchange is also known as Starker exchange and can apply to properties outside real estate. This strategy was permitted under the previously named code since 1921, when Congress passed a statute allowing taxation avoidance on ongoing property investments to foster reinvestment. Thankfully, the IRS 1031 exchange rules of 2021 are the same.
There are three types of 1031 exchanges – the delayed exchange offers 180 days to get a replacement property. Next is the reverse exchange, which involves closing on a replacement property before the sale of the relinquished one. Finally, the built-to-suit exchange allows the use of deferred tax money for replacement property renovation.
A common question among investors is, “Which states do not recognize 1031 exchanges?”. Since it is a federal law, it is acceptable everywhere; hence the possibility of 1031 exchange out of state. Nevertheless, some states like Pennsylvania don’t recognize the code.
How It Works
Generally, when making 1031 exchanges, investors aren’t mandated to recognize a loss or gain under the said IRC until the property receival fails to qualify as like-kind, especially a property held primarily for sale and not for investment purposes.
There’s no limit to how frequently you can do 1031 exchanges, so long as the property qualifies. Furthermore, 1031 exchange between states is possible.
1031 exchange empowers you to roll over your gain from one property to another without paying tax until you finally sell for cash years later. Once that happens, you make a one-time tax payment at a long-term capital gains rate (pegged at 15 or 20 percent depending on family or personal income – zero percent for even lower earners).
Similarly, you can change your investment form without cashing out on a capital gain. That way, you allow your investment to grow tax-deferred. Here’s the catch-all, 1031 exchanges must be of like-kind, meaning they must all be for investment or business purposes. Thus, you can exchange a raw strip of land for an apartment complex or a farm for some housing units.
The bottom line is that both properties have to be for investment. However, the rules can also apply to former primary residence properties under certain conditions, just like 1031 exchange out of state is a possible occurrence.
The Role of Qualified Intermediaries
Section 1031 of the Internal Revenue Code insists that any proceeds received from the sale of the property remains taxable. Thus, you must transfer the proceeds received from the property sale to a Qualified Intermediary and not the property’s seller, to ensure that they remain non-taxable. The Intermediary then sends the money to the seller of the replacement asset.
A Qualified Intermediary is an entity that functions to hold the funds in a 1031 exchange transaction until it is ready to be sent to the seller of the replacement asset. For fair business, the Qualified Intermediary must not have any personal relationship with either of the parties involved in exchanging property.
Ensure that the Intermediary you choose to handle your 1031 exchange is duly qualified, has substantial real estate experience, has acquired fund security, and runs a transparent practice. You can also pose burning questions such as “Which states do not recognize 1031 exchanges?” to your intermediary to determine the extent of their expertise.
The Effect of Depreciation on 1031 Exchanges
Understanding the effect of property depreciation is very crucial to appreciate the benefits of a 1031 exchange. Depreciation occurs over time and is the percentage of a property’s cost that ceases to count due to the action of wear and tear, appearing as a loss in property value.
When a property sells, the capital gain taxes are calculated based on the property’s original purchase price, including capital improvements. Depreciation losses no longer count towards the total value. Selling a property above its depreciated value results in a recapture, which results in the inclusion of the depreciation amount in the taxable income upon property sale.
Depreciation recapture increases over time, necessitating the adoption of a 1031 exchange to avoid an increase in taxable income. Such complications are reasons to hire professional help during a 1031 exchange, especially if you need an answer to this common question: “Does 1031 exchange avoid state tax”?
If you’re wondering whether your state supports it, you can research which states do not recognize 1031 exchanges and those that do.
Rules and Requirements of 1031 Exchange
Some rules and requirements govern the process of a 1031 exchange. These requirements come under time and property requirements, and some may vary per state, so it’s essential to know which states do not recognize 1031 exchanges.
Property Requirements
Any 1031 exchange must meet the following stipulated conditions and requirements:
- The replacement property must be of equal or more excellent value to the relinquished property. As explained earlier, both properties must be like-kind because they’re both for investment or business purposes. Remember that property in the United States can’t be of like-kind to one outside the U.S. soil.
- During the process, none of the parties can hold a profit made from a 1031 exchange, and all funds are kept in escrow by a Qualified Intermediary.
- Properties up for the 1031 exchange must be similar in nature and function. You can’t use primary residence properties and vacation homes for 1031 exchange. However, some loopholes permit the qualification of vacation homes, but that isn’t in the scope of this article.
- Bonds, stocks, securities, debts, trust certificates, and the like aren’t permissible to 1031 exchanges.
Time Requirements
1031 exchanges are time-specific, after which all proceeds and profits realized from selling the property become taxable.
The time requirements are as follows:
- You’re only allowed 45 days from the day of sale of relinquished property to get prospective replacement properties. The bid must be written and communicated to the seller or your Qualified Intermediary.
- You’re required to close on the replacement property within 180 days of the relinquished property. You may do so after your tax is due (whichever of the two comes first).
Conclusion
A 1031 exchange offers property owners the opportunity to keep a growing real estate investment portfolio without spending money on taxes. If you’re keen to save extra cash using this method, kindly reach out to a real estate agent near you to check if your state recognizes 1031 exchanges.
