If you’ve made plans to list a real estate property for sale, it’s a good idea to think about how you might reduce your tax liability.
In a typical sale, the property owner is liable for taxes on the derived revenue. A 1031 commercial property exchange offers itself as an excellent tool to not only postpone tax payments and reduce overall expenses but consequently increase the total valuation of your business holdings.
What Is a 1031 Exchange of Commercial Property?
If the revenue derived from the sale of a property is transferred directly into the purchase of another ‘like-kind’ property, such properties are referred to as 1031 exchange properties. The peculiarities of these exchanges are only applicable to commercial real estate transactions, not for residential properties or vacation homes.
Rather than selling the property and keeping the revenue, the investor must deposit the sale proceeds in a third-party account if they’ve decided to opt for a 1031 exchange. They then have 45 days to find a substitute property or properties for the initial asset. Then, within 180 days, or roughly 6 months, following the initial asset’s sale, the new acquisition must be completed.
As an investor, you can escape paying the outrageous expenses connected with taxes on value appreciation of property by acquiring another asset with the proceeds from the initial transaction. A 1031 commercial property exchange keeps the capital in the investment and out of your bank, avoiding immediate taxation on the increased value.
1031 Exchange Regulations
Specific IRS restrictions govern how 1031 exchanges are conducted, just as they do with other deal structures.
Keep in mind that if you eventually decide to sell your property via a 1031 exchange, an accountant and a real estate finance specialist will come in handy to keep things in order.
The following are some regulations you have to deal with upon opting for a 1031 property exchange:
- Like Transaction
This requirement by the IRS mandates that the original property and its replacement must be comparable in value to qualify as like-type.
- Deadlines
The investor is expected to have secured a replacement asset in the first 45 days following the sale of their initial asset otherwise they forfeit the tax deferment benefit afforded them by the exchange.
Completing a 1031 Exchange: A Step-by-Step Guide
To get through with a 1031 property exchange with as little hassle as you can afford, it’s crucial you keep a cavalry of taxation and legal specialists at your beckon.
These experts would see to it that you stick with all IRS regulations and reach your investment objectives with as little risk as you can realistically take on. The following are the necessary steps to stick to for a successful 1031 exchange:
- Make a Plan
Given the tight timelines associated with 1031 exchanges, as an investor, it’s critical that you make a detailed roadmap before listing your 1031 exchange real estate for sale. Start by assessing the sorts of substitute investments that best satisfy your investment objectives while adhering to the IRS’ big-brotherly regulations.
- Assemble a Group of People to Work on an Exchange Arrangement
You might already have an accountant or possibly even a team, and perhaps a tax advisor also. However, Internal Revenue Service regulations mandate that you delegate all funds handling to a third-party Qualified Intermediary (QI).
Also known in the industry as Exchange Accommodators, QIs attend to various different tasks regarding 1031 exchanges. Their duties vary according to whom they report to.
With investors, QIs buy properties sold by exchangers and transfer control over to property buyers. On the other hand, with property buyers, they purchase replacement assets from sellers and pass them on to buyers.
Considering that QIs are in charge of all revenue from the sale of sold properties pending their required release to purchase ‘like-kind’ others, it’s critical for you as the investor to select only a thoroughly verified QI.
- Select Assets to Exchange
New properties you’ve chosen to replace the old one must be comparable to the previous in terms of investment grade. Upon relinquishing your previous assets, you have a total of 45 days to select up to three properties for replacement.
As long as the total worth of your chosen new properties doesn’t surpass 200 percent of the sale price of your original property, the rules allow you to select more than three properties.
- Arrange for Acquisition Funding
Upon clearing the debt on your sold original property, it’s recommended you substitute it with a property whose debt burden is roughly equivalent.
Double-check to make sure you have the financial resources or capital backing to purchase on time.
Considering that you only have 180 days after disposing of the previous asset to finalize the exchange, take extra care to ascertain that this component of the jigsaw snugly matches before starting the procedure.
- Complete the Transaction
After securing a new asset and hooking on to it, your QI takes over. They kick into action and complete all legal documentation mandated to meet the exchange requirements.
Since you’re required by legislation to keep off proceeds from your initial sale, they remit payments in your stead to the firm on the other end once the purchase has been finalized. Keep in mind that it’s crucial you buy the property intended as a replacement within 180 days of selling your original property or you forfeit the exchange as well all benefits afforded to the exchange entirely.
Consider keeping the individual steps in mind the next time you decide to explore 1031 exchange properties for sale.
Advantages of a 1031 Exchange
Since we’ve brought you reasonably up to speed as to how a 1031 exchange operates, it’s time to go over the major benefits obtainable from this process.
- Postponement of Tax Payment on Capital Gains
If you opt for the traditional approach and sell investment property without heading for a 1031 exchange, we need not tell you that you would get slammed with a barrage of taxes.
Your earnings could be eroded by as much as 35 percent, courtesy of all those taxes. Purchasing one of those 1031 exchange properties for sale guarantees that you get to delay payment on all of these obligations for as long as you like.
- Possibility of Increased Revenue
Say you’ve held a rental property for 15 years and it’s witnessed a tremendous increment in value. As against relinquishing a large portion of that increment to the IRS, you can deposit all that money in an investment fund when you purchase one of those 1031 exchange properties for sale and you’d enjoy better yearly rates than your original property, say a vacation home, gave you.
- Increased Valuation of Business Holdings
1031 regulations allow that you trade into larger assets as time goes on, enabling you to increase the value of your total holdings. You get to pass down these assets to your descendants who may get to avoid any taxation on the outright sale of the passed-down assets.
Believe us when we say that it’s a good time to sell a house in California and when you’ve wrapped your head around the whole concept of 1031 exchanges, best you look up where to list your 1031 exchange property for sale in Palo Alto or wherever you prefer
The Drawbacks of a 1031 Exchange
However, like with any trade-off, there are certain drawbacks to completing a 1031 exchange. We’ve compiled a list of them for your assessment.
- Taxes are Merely Postponed
Gains taxes are postponed as against being eliminated when you opt to complete a 1031 exchange. As such, the next time you decide to look up an agent’s 1031 exchange properties list, remember, ultimately, it’s on you to clear those delayed taxes if you resell your exchange property without executing another 1031 exchange.
- IRS Restrictions are Quite Strict
1031 exchanges are subject to strict IRS requirements and to avoid any missteps, you must rely on your QI’s expertise here. For one, the new asset you intend to replace the previous must have an investment grade that’s equivalent to your previous assets. Any more and you have zero leeway.
For another, you must stick to the mandated, 45-day, and 180-day purchase and documentation finalization timeframes, or you risk forfeiting the deal altogether.
- Depreciation Base Is Reduced
The revised basis of your original property is used to gauge devaluation in a 1031 exchange replacement asset. This is often less than what you’d get if you had acquired the property traditionally.
Final Thoughts
As your capital will be locked up in a commercial property that you can’t dispose of quickly without incurring hefty taxation, 1031 exchanges should be regarded as a long-term investment plan.
As exchanges might take place all over state boundaries, it’s critical to understand the tax structure and laws of the jurisdictions where potential replacement properties are situated. So a 1031 exchange has a time constraint, it’s a good idea to start looking for replacement properties before selling your primary investment.
Investors choose a 1031 exchange for a variety of reasons. Discussing your investment objectives with knowledgeable specialists will help you determine if this is the right option for you.
