Investing directly in real estate involves buying a stake in a specific property, as opposed to passively buying shares in a fund or a publicly or privately held company that invests in real estate – such as a Real Estate Investment Trust (REIT). Direct real estate investments, consisting of residential or commercial rental investment properties, require knowledge of leasing, mortgage loans, tenant and landlord relationships, and property management. Additionally, if a direct real estate investor desires to update their strategy by selling one property to invest in a new investment property, they may face significant liquidity and income tax challenges.
When an investor sells an investment property that has appreciated in value for cash, an obligation to pay capital gains taxes on the profit arises, which is the difference between the sale price and the adjusted basis. In general, the adjusted basis is the asset’s original purchase price, plus any acquisition costs and the cost of capital improvements, minus previously taken depreciation deductions and any deferred capital gains. Deferring resulting capital gains may be accomplished through the implementation of a technique known as a “1031 Exchange.” A 1031 Exchange allows an investor to effectively “swap” real estate like kind properties without incurring significant income tax consequences at the time of the transaction. An investor may implement an exchange to meet changing investment goals, such as moving from residential properties to commercial properties or shifting focus to different geographic areas, without triggering capital gains taxes.
The primary benefit of a 1031 exchange is income tax deferral. By reinvesting the proceeds from the sale of one property into a replacement property, the taxpayer can defer paying capital gains taxes until a future taxable event, such as selling the replacement property for cash. It is important to note that the cost basis of the relinquished property carries over to the replacement property, plus adjustments. This means that any accumulated depreciation deductions will also transfer to the replacement property (depreciation recapture). As a result, the basis of the replacement property will usually be lower, which could potentially increase future taxable gains when sold. However, by deferring taxes through a 1031 exchange, an investor can potentially have more funds available for reinvestment. Investors can prospectively leverage the increased cash flow to acquire additional properties with even higher income potential.
Utilizing a 1031 exchange strategy during life can also be a useful technique for estate planning. Upon a real estate owner’s death, the investment property will receive a stepped-up cost basis to its fair market value under current law. Should beneficiaries desire to sell the property shortly after death of the property owner, there may be a benefit from limited or no capital gains tax exposure. This strategy could shelter multiple properties from capital gains taxes.
1031 exchanges are highly regulated by the IRS, which has established specific rules and requirements to qualify for the tax-deferred treatment:
- “Like-kind” requirement: An investor cannot use the proceeds of a real estate investment to purchase a different form of investment, such as stocks or bonds. The IRS views real properties to be “like-kind.”
- Boot and Tax Liability: “Boot” refers to any property or cash received or given in a 1031 exchange that is not “like-kind.” Any cash or other non-like-kind property included as part of the exchange, will incur immediate tax liability on that portion of the transaction.
- Qualified use: The properties involved must be held for productive use in a trade or business or for investment purposes. This generally includes real estate properties such as commercial buildings, rental properties, vacant land, and certain types of personal property.
- Qualified intermediary: The investor must use a qualified intermediary, which is an independent third party, who facilitates the exchange and holds the funds from the sale of the relinquished property.
- Tax Reporting: The IRS requires the reporting of 1031 exchanges on tax returns to report the exchange details, including the identification and value of the relinquished and replacement properties.
- Depreciation Recapture: A 1031 exchange does not eliminate the depreciation recapture requirement. When a replacement property is sold in the future, any depreciation recapture is typically subject to tax at a maximum rate of 25%.
- Timelines: The taxpayer must identify a replacement property within 45 days of the sale of the relinquished property. Additionally, the exchange must be completed within 180 days, which includes the 45-day identification period.
Source: https://mekhtiyevlaw.com/real-estate/1031-exchange/
In addition to meeting IRS regulations, investors have additional challenges. The strict timelines associated with 1031 exchanges can limit flexibility in finding and acquiring a suitable replacement property within the specified time constraints. This could potentially lead to rushed decisions or the inability to find an ideal replacement property, which may bring unintended financial consequences. A 1031 exchange involves additional administrative and transaction costs that should be factored into any financial analysis and in the investor’s decision-making process. These costs typically include fees for the qualified intermediary, legal and tax advisory services, property appraisals, and other associated expenses.
When implemented appropriately, a 1031 exchange strategy can be useful for tax deferral, diversification, estate planning, and wealth accumulation. By deferring taxes and reinvesting the proceeds into a replacement property, over time, the appreciation of the replacement property and the ability to leverage the property’s equity can contribute to long-term wealth creation. It is advisable to consult with a qualified tax professional or attorney with expertise in 1031 exchanges to ensure full compliance with the applicable regulations. Eagle Ridge Investment Management, LLC regularly helps clients analyze their cash flows and understand the implications that various financial decisions will have on their individual circumstances, including 1031 exchanges. Please let us know if we can be of any assistance in this regard should you be considering such a transaction.