What is a 1031 Exchange?
A 1031 exchange is defined by the Internal Revenue Code (IRC) section 1031. A 1031 Tax Deferred Exchange offers taxpayers one of the last great opportunities to build wealth by “trading up” to a larger or higher-quality property while deferring capital gains taxes. By completing a 1031 Exchange, the Taxpayer (“Exchanger”) can dispose of investment or business-use assets, acquire replacement property and defer the tax that would ordinarily be due upon the sale. With help from a tax professional or attorney and a licensed broker from Marcus & Millichap to lead you down the right path, this can be a great tool to access your current equity.
Since 1921, section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets, giving you the ability to defer the taxes that would otherwise have been due from the sale.
A 1031 Exchange allows investors to defer federal capital gains tax, state ordinary income tax, net investment income tax, and depreciation recapture on the sale of Investment property if certain criteria are met including:
• Buy replacement property for equal or greater than sold for and reinvest all proceeds
• Identify replacement property within 45 days of close of sale
• Purchase replacement property within 180 days of close of sale
• Must Sell and Buy property that is considered “like-kind” to each other
• Process must be handled by a Qualified Intermediary (QI)
While 1031 exchanges have gained increased popularity, each investor should take the time to evaluate their own situation and if this is the right move for them. The first step in this process is to have a qualified Marcus & Millichap agent evaluate your property and determine its market value. Then this information should be taken to a tax advisor to get a well-rounded scope of your particular situation. Some circumstances may dictate paying cash or taking a line of credit for a new property purchase depending on interest rates. In other instances, the 1031 exchange may be the way to go. The bottom line is that you need to talk to licensed professional and know your options.
Who can use 1031 Exchanges?
All businesses, manufacturers, real estate investors, companies in the construction, trucking, rail, marine and equipment leasing industries, farmers, ranchers, individuals and beyond can take advantage of 1031 exchanges. The 1031 Like-Kind Exchanges are one of the few incentives available to and used by taxpayers of all sizes. A recent industry survey showed that 60% of exchanges involve properties worth less than $1 million, and more than a third are worth less than $500,000. Qualified Intermediaries (QI), such as a Marcus & Millichap broker can facilitate non-simultaneous tax-deferred exchanges of investment and business use properties for taxpayers of all sizes, from individuals of modest means to high net worth taxpayers and from small businesses to large entities. Marcus & Millichap is the largest real estate firm that is focused solely on investment brokerage and are one of the industry’s leaders in 1031 exchanges. We have cultivated long term relationships with owners and investors of every major property type which will allow us to match your property and exchange buyers with speed and efficiency.
Knowing the Basics
While there are three basic types of exchanges- simultaneous, reverse and deferred- 95 percent are deferred. When selling an investment property, the code allows a seller 45 days from the close of escrow of the relinquished property (the “down leg”) to identify up to three replacement properties (the “up leg”), and an additional 135 days to close escrow on at least one of the identified properties. Alternatively, more properties can be designated if certain valuation tests are met. The seller must contract with a neutral third party, know as a qualified intermediary or accommodator, to hold the funds form the sale of the relinquished property and to purchase the replacement property for the seller’s benefit. Completing this process allows sellers of real property held for investment purposes to delay or defer the payment of capital gains and recapture the depreciation tax benefit. Deviating from the process described above may result in tax consequences or costly penalties.
Will the tax ever go away?
With 1031 Exchanges, taxes are deferred but not eliminated. These legitimate transactions utilize an important tax planning tool which is why it is crucial to consult both a licensed leader in the field of 1031 exchanges such as a Marcus & Millichap broker and a qualified tax professional. The payment of tax occurs:
1. upon sale of the replacement asset;
2. incrementally, through increased income tax due to foregone depreciation; or
3. by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.
Reasons to Exchange
There are many reasons to exchange, such as:
• Defer Taxes: Federal, State & Depreciation Recapture
• Diversify or Consolidate a Real Estate Portfolio
• Increase Cash Flow
• Switch Property Types (Land, Industrial, Multi-Family, Office, Retail, Residential, Easements)
• Get into Other Real Estate Markets (Exchange anywhere within the U.S. & Territories)
• Build & Preserve Wealth
• Set up Heirs for the Future (Estate Planning: Stepped Up Basis)
• Increase Purchasing Power
Why Your 1031 Intermediary Choice Matters
If you are considering a 1031 tax deferred exchange to defer taxes when you sell your investment property, a “1031 Qualified Intermediary” (QI) is generally required. This usually means turning to a CPA, real estate agent, attorney or broker. A broker is a common choice to play the role of the QI, but be sure to vet out a reputable investment brokerage like Marcus and Millichap. This should be done prior to the transfer of the old investment property to prepare the necessary documentation, securely hold your exchange funds and acquire your new investment property.
However, since almost anyone can act as a 1031 Qualified Intermediary, here are some important factors to consider:
• 1031 Intermediaries are not regulated by the federal government and most states: This means that there are no uniform regulations or laws concerning how your funds are deposited, invested or secured by QIs. Many years ago, some investors lost their exchange funds when they were either stolen or poorly invested by unscrupulous QIs. In many instances these losses could have been avoided by conducting basic due diligence prior to selecting the QI.
• Safety and Security for the transfer of your funds: With cybercrime and fraud on the rise, bank wire transfers, particularly regarding real estate transactions, have been increasingly targeted and are amongst the most costly types of cybercrime today. Selecting a QI that has a secure computer network and updates its safety precautions for holding and transferring funds would be a wise choice.
• Financial Assurances for your funds: Since 1031 Intermediaries are not regulated by the federal government or by most states, they are not uniformly required to provide insurance or other protections for your exchange funds. Therefore, if your funds are lost or stolen by a QI that doesn’t provide adequate protections, the loss is borne by you.
• Expertise and Strength: Similar to the lack of uniform regulation, QIs are not licensed by the federal government or by most states. This means that just about anyone can act as a QI without any training or education regarding 1031 tax deferred transactions.
• Reputation: Although QIs are not regulated by the federal government, there is an industry trade association, Federation of Exchange Accommodators (FEA). Many reputable and stable QIs are members of this organization.
*Source: ipx1031.com
*Source: mmreis.sharepoint.com