Why 1031 or reverse 1031 exchanges need to be part of your strategy
I always knew the potential of Real Estate to make long-term wealth, but I wasn’t sure if it would ever be a draw for me to do it full time.
I am a die-hard problem solver, and RE just seemed not so intellectually stimulating from the surface.
That all changed when I dove in and realized its archaic nature filled with challenges, and challenges mean opportunities with the right mindset.
Also, one of my values when pursuing projects is having a variety of options at hand since that lets me pivot anytime an option does not energize me - feeding my mission of living a life of spontaneity.
But then I also realized Real Estate is brimmed with options to experiment with.
1031 exchange is one of the options that just makes it a no-brainer to include in your big-picture strategy.
So if you want to understand more about a 1031 exchange and want to defer capital gain taxes on your next real estate investment sale, keep reading. 😎
Why is it important to know about 1031 exchanges?
You must pay taxes on the capital gain at the sale if you sell an investment property, just like any other type of investment. But one of the many tax benefits you enjoy as a real estate investor is the capability of performing a 1031 exchange.
What is it?
Section 1031 of the United States Internal Revenue Code, which enables real estate investors to postpone a capital gain by reinvesting the sale proceeds in one or more properties of equal or greater value, is referred to as a "1031 exchange".
In short, if you sell something, you don’t have to pay taxes on the profit; if you simply re-invest the profit in another property(with some caveats).
What are the caveats?
The first rule for a 1031 exchange is that you cannot touch the sale proceeds. Therefore, when you sell a property, the sale proceeds must be given to a qualified intermediary, a third party.
The funds are held by this qualified intermediary, a third party until they are transferred to the seller of the property you choose to buy.
This stage of the procedure is crucial. Before selling the property, you must determine whether or not to do a 1031 exchange because if you touch the sale proceeds and they are distributed to you at the end of escrow, the 1031 exchange is null and void. You are no longer able to delay paying capital gains taxes.
So, assuming you've identified a trustworthy intermediary, you'll need to find a property of a similar nature to exchange into.
Now, it need not be the same kind of property. So long as it generates money, you could purchase a retail shopping center, an office building, or an industrial warehouse, even if you were selling a multifamily property.
To defer all of your capital gains taxes, you must also ensure that the replacement property is worth at least as much as the one you're selling or more.
As a commercial real estate investor, you will undoubtedly have many options for the kind of replacement property you like.
So you must adhere to a few specific restrictions to guarantee that you comply with the 1031 exchange regulations.
Formal identification of one or more properties you'll exchange must be made within 45 days of the closing date of the property you're selling.
Some rules to follow
You should identify as many properties as possible when locating them because you want to keep your options open if one or more of them don't work out. However, some rather stringent rules must be followed while identifying these deals.
The first method is the Three Property Rule, which asserts that you can identify a maximum of three commercial real estate properties regardless of their market worth.
This could be an excellent alternative for you if you are confident that you can close on at least one of the three houses.
The second criterion you may use is the 200 percent rule, which permits you to identify an infinite number of properties as long as their combined worth does not exceed 200 percent of the property you just sold.
This could be a terrific rule to follow if you have numerous properties that are perhaps smaller than the one you recently sold and want to identify more than three properties.
Another rule that can identify an endless number of properties is the 95 Percent Rule, which is the last. Using this strategy, you must close on 95% of the total value of all the properties you've chosen.
So again, this could be a great alternative if you want to purchase several smaller properties after a deal is closed. Investors frequently trade up from smaller properties into bigger ones. So this would be a contrarian approach, but worthwhile may be depending on your strategy.
Your replacement property or properties must be chosen and closed within 180 days of the closing of the transaction you are exchanging.
So 180 days for closure and 45 days for identification.
Another variation of the 1031 exchange is the reverse 1031 exchange, which enables an investor to buy the replacement property even before reselling the property being exchanged.
In this case, the replacement property will be held by a party known as the exchange Accommodation Title Holder.
The investor will then have 45 days to identify the property they intend to sell and 180 days to complete the sale and close the deal.
The property that was first bought to start the 1031 exchange will be transferred from the exchange accommodation title holder to the real estate investor after that sale is finished.
I strongly believe a 1031 exchange can be a great strategy if you are playing the long game and mostly care about the cash flow from Real Estate.
Every few years, if the economic conditions are right, you can just use the proceeds to keep buying bigger assets without the capital gain taxes.
Though, I strongly recommend that you have knowledgeable professionals on your side, such as 1031 exchange experts, accountants, and attorneys who are thoroughly familiar with the process, at least for the first time you do it.
Your 1031 exchange may be void if you make a mistake or engage incorrectly, and you will probably have to pay capital gains taxes on your sale, which you were attempting to avoid by doing this in the first place.
Thank you once again. I really do appreciate people reading.