A 1031 exchange can help defer your capital gains tax liability and diversify the investment portfolio. However, one thing that can complicate the matter is the time crunch associated with the 45-day identification period.
According to the 1031 exchange rules, an investor must identify the right replacement property within 45 days of selling their investment property. Moreover, they get only 180 days from the day of selling the investment property to complete the entire 1031 exchange process.
That being said, the 1031 exchange can get complex. But, with the right knowledge, you can make this process as streamlined as possible.
Here are the top 4 strategies to help you conduct a successful 1031 exchange.
What Is A 1031 Exchange?
A 1031 exchange is a tax-saving tool that allows investors to defer capital gains taxes.
Simply put, selling an investment property in the US can lead to the realization of capital gains tax liability on the sales proceeds. This liability can range from 35% to even 45% of the total sales proceeds.
However, with a 1031 tax-deferred exchange, investors can reduce their capital gains tax liability if they sell an investment property and reinvest 100% of the sales proceeds in a like-kind investment property.
1031 Exchange Rules To Keep In Mind
To conduct a successful 1031 exchange, you must remember the rules. For starters, the replacement property (the new property you will reinvest your sales proceeds in) must be a like-kind property. This does not necessarily mean that the real estate asset you are selling (relinquished property) and the replacement property must be of similar grade or character.
You can exchange a multi-family apartment with assisted living or even an oil and gas field. The crux here is that the replacement property must be like-kind – it must be held for investment purposes, i.e., for business or use in trade.
Moving forth, the entire process must be completed within 180 days of selling the investment property. This implies that everything from identifying the eligible replacement property to closing must be done within this time.
On average, investors get 45 days to identify the replacement property and the remaining 135 days to close on the property.
Another rule is that a Qualified Intermediary (QI) must impound the sales proceeds. You must get in touch with the right QI for this. Moreover, the investor must reinvest 100% of the sales proceeds. In case they fail to reinvest some of the proceeds, they’ll trigger tax liability on the amount they didn’t reinvest.
4 Strategies For A Successful 1031 Exchange
Here are four expert tips you can follow to complete your 1031 exchange in time:
Sign all exchange documents before the closing.
To start a 1031 exchange, you must sign the exchange documents. By signing these documents, you can convert a sale of the property into an exchange. Once signed, you will have a timeline to complete this process.
If you fail to sign the documents, the IRS won’t be notified about your intentions of doing the exchange and will consider the sale of the property as taxable.
Traditionally, exchange documents include an assignment of rights to sell the relinquished property, a notice to the assignment’s buyer and an exchange agreement between you and the QI. This document must be signed on or before the day you close on your investment property sale. A QI can assist with the required documentation.
Consider who will acquire the replacement property
The replacement property must be purchased by the same taxpayer who sold the property that was given up. How would you respond if your lender demanded that you buy the replacement property through a single asset entity? Because a single-member limited liability business is ignored for tax reasons, this is feasible. So, as long as he is the only member and owner of the LLC, an investor can sell the property he has given up that he has owned personally and buy the replacement property through an LLC.
Acquire enough replacement properties to defer all gains
You must do two steps in order to entirely postpone all of the tax that you otherwise would have to pay on the gain. You must first purchase a replacement property that is as least as valuable as the property you are giving up. In other words, if you sell anything for $1 million, you must buy replacement property worth at least $1 million; otherwise, the sale would be partially taxed. The second requirement is applying the whole net equity from the sale to the buyer.
You must put the entire $700,000 you net from the sale into the replacement property to fully postpone taxes if you sell a home for $1 million with a $300,000 debt on it (expenditures are not included to keep the example easy). To replace the property in this example, you would need to pay at least $1 million for it, put $700,000 into it, and borrow $300,000 or put $300,000 of your own money into it.
Consider the expenses
Some costs that can be covered with exchange profits do not subject the transaction to partial taxation. Examples of this expenditure include brokerage commissions, escrow fees, exchange fees, and transfer taxes.
On the other hand, if you offer the buyer a credit for security deposits or rent already paid when you sell the surrendered property, you are utilizing exchange profits for non-exchange expenditures, and your exchange may be partially taxed. Thus, if you don’t want to pay any tax, you should pay these in cash when you arrive.
Summing It Up
Finally, a 1031 exchange is an effective tax method that enables real estate investors to postpone paying taxes on the sale of investment properties. Investors must abide by a series of laws and regulations, including investing in like-kind properties, working with a qualified intermediary, and keeping to rigorous deadlines for finding and closing on replacement properties to be eligible for a 1031 exchange.
The advantages of a 1031 exchange can be substantial, allowing investors to protect and reinvest their cash into new properties without incurring immediate tax consequences, even if the procedure can be complex and time-sensitive. Investors who are knowledgeable about the requirements and procedures of a 1031 exchange may benefit from this advantageous tax planning tool and make wise judgments.
We help you connect with best-in-class investment and finance advisors, who analyze your investment goals and allow you to meet them in time. We also offer a custom 1031 property list, that helps you find replacement property within 3 days. For more information.
