Advantages and Disadvantages of 1031 Exchange for Realtors
Nothing is certain in life except death and taxes. These famous words by Ben Franklin were said before the introduction of the 1031 exchange.
While death is still inevitable today, the same is not true of taxes.
Investors have various options when it comes to avoiding taxes, and the 1031 exchange is one prime option that can help save hundreds in taxes.
In this blog post, we will let you know more about a 1031 exchange, explain the requirements, and highlight some of the benefits and disadvantages of the investment incentive.
What Is a 1031 Exchange?
A 1031 exchange is described under Section 1031 of the US Internal Revenue Code (IRC). Realtors who structure their property exchange meeting the 1031 exchange rules can avoid or minimize taxes.
The gains from most property swaps are taxable. But if yours conform to the needs of the 1031 exchange, you can reduce or avoid taxes altogether.
Also known as a like-kind exchange, the 103 exchange in effect allows you to swap of one property for another without having to pay any taxes.
While you may actually profit from each profit swap, you won’t have to pay profit until you sell the property years later. You can then sell your property and pay only one tax at a capital gains tax that ranges from15 to 20 percent for most taxpayers and even 0 percent for low-income taxpayers.
Legal Requirements for 1031 Exchanges
The IRS has laid out a number of requirements for availing the 1031 exchange tax benefits.
Time Limit
You can carry forward gains from one real estate property to another for unlimited periods. There is no limit as to how many 1031 exchanges you carry out.
However, as per the IRS rules, you are allowed about six months (or 180 calendar days) between the sale of one property and the purchase of a replacement property.
Also, you need to identify the replacement property within one and a half months (or 45 calendar days) of the closing of the sale of a property deal.
You must identify the replacement and relinquished properties in a letter sent to the Exchanger. The Exchanger will assess whether the properties mentioned in the letter meets the requirements.
Type of Properties
The properties that are sold and bought must be held for use or investment in a business. The term ‘like-kind’ is used by the IRS for qualified properties. You can exchange any property that is held for business use or investment with another ‘like-kind’ property.
Both developed and underdeveloped properties come within this definition. You can exchange a ranch for an apartment or farmland for a mall. The laws are liberal regarding what properties you can exchange. But it excludes primary residence of the realtor and ‘held for sale’ properties.
The properties that are sold and replaced do not need to be identical. You can sale a commercial property and buy a residential property. The main point is that both the properties must be held for business use or investment. The size and type of property are irrelevant for determining the 1031 exchange criteria.
Number of Properties
Investors can identify multiple replacement properties. The 1031 exchange’s Three Property Rule allows investors to identify up to three properties. There is no limit to the total market value of the properties.
Alternatively, you can identify any number of properties as per the 200 Percent Rule, as long as the market value of all the properties is less than twice the value of the relinquished properties.
Qualified Intermediary
The 1031 exchange rules require investors to work with a “Qualified Intermediary”. The intermediary who is approved by the IRS will prepare the necessary documents for the exchange of properties. Moreover, the intermediary will also structure the exchange of like-kind properties to ensure that it meets applicable laws.
Investors have to spend all the proceeds from the sale of property in buying another property. The proceeds can be greater or less than the value or the sold property. Any amount that is not invested in buying a replacement property will be taxable.
What Are the Benefits of 1031 Exchanges?
The foremost benefit of the 1031 exchange is that helps in deferring taxes. Investors can defer depreciation recapture, income, and capital gain taxes. These taxes can be significant particularly in the case of a low adjusted cost basis.
Another benefit of the 1031 exchange is that it allows you to have more money for investment. You will have increased purchasing power to buy attractive real estate properties. The tax incentive allows you to invest in one or multiple properties that have higher return potential.
You will have more money in the bank when you use this option as compared to selling a property and paying the associated taxes and buying a new property.
With 1031 exchanges, you can accelerate the wealth building process. The option will lead to significant cash flow improvement, particularly for commercial property investors.
The 1031 exchange can help realtors save thousands of money on taxes. You may never have to pay taxes on the sale of properties. You can defer the taxes by investing for as long as they want thereby availing better investment opportunities.
What Are the Cons of 1031 Exchanges?
While 1031 exchanges are a great tool to boost investment returns for realtors, you should also know about certain disadvantages. Most investors hit roadblocks when it comes to meeting the 180/45 days rule. Finding replacement property within 45 days and buying the property within 180 days of a sale is not always possible. What’s worse is that the IRS does not allow any extension to the time limit.
Another con of this option is that losses are also deferred. You cannot realize the losses at the time of purchase of a new property. This can have a negative effect on your overall tax due to the IRS. That’s why it’s important that you consider the option carefully before using it for investment purposes.