What is a 1031 Exchange?
Simply put, a 1031 exchange (sometimes referred to as a like-kind exchange) is an opportunity to avoid paying capital gains taxes at the time you sell certain real estate. More specifically, it allows you to “park” (with an intermediary like a title company) your sales proceeds from the sale of real estate held for business or investment use and then use the sales proceeds to buy other business or investment real estate in a way that avoids the payment of the capital gain that would otherwise be due at the time of the sale of real estate. You must buy one or more qualified replacement properties as part of a 1031 exchange.
Why would I do a 1031 Exchange?
Anyone that is facing a substantial capital gain upon the sale of real estate should consider whether they are better off paying the capital gains taxes and pocketing the net proceeds, or whether they would benefit to keep their “pre-tax” dollars working for them (to produce a return or otherwise acquire one or more business or investment properties). Depending on your tax rate, this could amount to a substantial difference in how much value is working for your benefit. For example, if the federal and state capital gains tax rate was 26% and you were selling property in which you have a $100,000 capital gain – one option would be for you to pay $26,000 in tax, and invest the $74,000 in something other than real estate. Alternatively, you could do a 1031 exchange, buy replacement real property equal to or greater than the sales price of the property you are selling, and keep all $100,000 working for you. Of course, you could also do a 1031 exchange, buy replacement property for less than the value of what you are selling and pay a portion of the taxes, and keep the other portion working for you. In this example of having $100,000 vs. $74,000 working for you, if you assume you receive a 5% return after the sale in both scenarios then you would receive $5,000 if you had done a 1031 exchange and $3,700 if you did not. Your return is over 35% higher from having done a 1031 exchange!
More About 1031 Exchanges and Applicable Requirements
1031 Exchanges have become an extremely popular tax deferral technique in relation to real estate transactions. If you own real estate which you hold for business or investment use which would cause you to incur a capital gain on the sale of your real estate, a 1031 exchange is something you should consider. A 1031 exchange essentially involves the sale of real estate where the funds are deposited with a qualified intermediary pursuant to an exchange escrow agreement and then reinvested in real estate within certain periods of time. Specifically, you have 45 days from the sale of your real estate to designate one or more properties (but there are certain rules for designating more than 3 properties) that you intend to acquire to “replace” the real estate you sold. You then close on the purchase of the “replacement” property(ies) within 180 days of the date you closed on your initial sale. The buyer of the “replacement” property needs to be the same taxpayer as the seller of the initial real estate sold. There are no extensions possible under the exchange rules so the deadlines (45 days to designate and 180 to close on the purchase of real estate) are firm.
What is a Reverse 1031 Exchange?
A reverse 1031 exchange involves changing the order from a conventional 1031 exchange (where you sell, then buy) so that you buy first, and then sell. Reverse 1031 exchanges are more complex than traditional 1031 exchanges in that they involve another party actually taking title to the property being acquired and leasing it back to the exchanging party.
Contact Us to Discuss Whether a 1031 Exchange Makes Sense for You
We have been helping clients with their 1031 exchanges for decades. Our experience has allowed us to become familiar with the types of issues that are often overlooked so we can help our clients avoid unintentionally taking any actions that put the tax treatment of the client’s 1031 in jeopardy. The key is to communicate with your attorney in advance of the planned 1031 exchange so that all contractual language is in place in regard to the contract to sell, the exchange escrow agreement, the designations, the assignments to the intermediary, and the contract to purchase.
What is the Cost of a 1031 Exchange?
In most exchanges we can charge a flat fee which includes drafting all required 1031 documents and guiding you through the process. We can assist in most routine 1031 exchanges for a fixed fee of $600. Intermediaries will charge separately for their services but oftentimes their fees are near $300. Some exchanges will involve research questions or complex requirements that can increase the fees but those situations can usually be identified at the outset so you can plan accordingly.
Of course reverse exchanges are more expensive due to the different structure involved. Our fees for reverse 1031 exchanges start at $1,000, and the intermediaries (called accommodation parties in the context of reverse exchanges) oftentimes charge $500 for their part.
Contact us today to assist in your 1031 exchange. We would be happy to help you keep your “pre-tax” dollars working for you!