The term 1031 Exchange (aka a“Starker exchange” or a “Like Kind exchange”) is defined under section 1031 of the IRS Code. (1) To put it simply, a 1031 exchange allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained by the sale of the first property. We’ll discuss like-kind property in more detail in section four.
Brandon Turner from Bigger Pockets explains that a 1031 exchange has more benefits than just saving yourself from taxes.
According to Brandon, a 1031 exchange can allow a real estate investor to shift the focus of their investing without incurring the tax liability. For example, perhaps you are investing in properties that are low-income and thus high-maintenance. You could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. Or perhaps you want to move your investments from one location to another without the IRS knocking. The 1031 makes this possible. (2)
Note: Traditionally, a 1031 exchange is where one property is literally swapped for another property of like-kind. However, the likelihood that the property you want is owned by someone who wants your property is really, really unlikely. According to Forbes, this is why “the vast majority of exchanges are delayed, three party, or “Starker” exchanges (named for the first tax case that allowed them). In a delayed exchange, you need a middleman who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you. This three party exchange is treated as a swap.” (3)
When you sell an investment property, even if you weren’t the one who initially purchased, you end up on the hook to pay capital gains tax.
If you’ve made some bad investments, or you just have bad luck, selling your investment can cost you more than you make.
But, if you own a rental property that is worth significantly more today than what you (or the original owner) purchased it for, you can make a killing by doing a 1031 exchange.
The big question: how should you do your 1031 exchange in 2017? Continue reading the next section to learn some tips and strategies for success!
To do a 1031 exchange effectively, you must exchange one property for another property of similar value. In the process you avoid capital gains, at least for a while.
An investor will eventually cash out and pay taxes, but in the meantime, an investor can trade properties without incurring a sudden tax obligation. It’s an important tool for real estate investors that has become a bulls-eye for tax reform evangelists.
However, the 1031 Exchange Rules require that both the purchase price and the new loan amount be the same or higher on the replacement property.
That means that if an investor were selling a $1 Million property in San Jose that had a $650,000 loan, they would have to buy $1 Million or more of replacement property with $650,000 or more leverage.
We’ll talk more about 1031 exchange rules in section 5. First, you’ll want to know about the four types of Starker Exchanges used by real estate investors.
When it comes to doing a section 1031 exchange with real estate, there are four main exchange types investors can choose from. The most common like-kind exchange types include the simultaneous, delayed, reverse, and construction/ improvement exchange. Continue reading to learn more about each type of exchange.
This allows investors to relinquish and close on a replacement property in the same day. Originally, this is what a 1031 exchange was–a direct exchange between two parties.
Today, this type of exchange isn’t very common. Why? Because what are the chances that the person who owns the exact property you want also wants the exact property you own? It can happen, but the possibility is pretty slim.
The delayed like-kind exchange is by far the most common type of exchange chosen by investors today. This type of exchange gives investors a maximum 180 days after the sale of their property to identify replacement property.
Note: we’ll discuss the rules associated with a Delayed Starker Exchange in the next section.
In theory, the reverse 1031 exchange is very simple: you buy first and you pay later. What makes it difficult, however, is that this type of exchange must be an all cash purchase AND most banks won’t lend to you. Why is it so difficult to get a loan? It’s because you cannot be on title to the replacement and the relinquished property at the same time.
The solution: you can create an LLC that can take title to the replacement property. Once you sell the original property, you can transfer the title of the replacement property into your name.
There are a lot of investors that sell a property, and realize that the one they want to buy costs less than the one I relinquished.
What do you do? Well, since paying taxes is out of the question…you might consider doing a Construction or Improvement Exchange.
This type of exchange allows you to use the remaining funds to build or improve on the property you want to buy.
To qualify as a 1031 exchange, the property being sold and the property being acquired must be “like-kind.” This is a very broad term, meaning that both of the properties must be “the same nature or character, even if they differ in grade or quality.” In other words, you can’t exchange farming equipment for an apartment building, because they’re not the same asset. In terms of real estate, you can exchange almost any type of property, as long as it’s not personal property.
**It’s important to note that the original and replacement properties must be within the U.S. to qualify under section 1031.
**Another fun fact: When using a Starker Exchange doesn’t have to be a 1-1 exchange. For example, you can exchange one property for multiple replacement properties and vice versa: you can exchange multiple properties and for one larger property. As long as the new properties are like your original properties, you’re good to go. Do yourself a favor and get a good qualified intermediary to assist you.
A 1031 exchange is only applicable for Investment or business property, not personal property. In other words, you can’t swap one primary residence for another.
In order to completely avoid paying any taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold. Otherwise, you will not be able to defer 100% of the tax.
For example, let’s say you have a property worth $2,000,000, and a mortgage of $500,000. To receive the full benefit of the 1031 exchange, the new property (or properties) you purchase need to have a net worth of at least 2 million dollars, and you’ll have to carry over at least a $500,000 mortgage. It’s important to note that the $2,000,000+ value, and $500,000 mortgage, can go towards one apartment building or three different properties with a total value of $2,000,000+. (FYI: Acquisition costs, such as inspections and broker fees also apply toward the total cost of the new property.)
A Taxpayer Must Not Receive “Boot” from an exchange in order for a Section 1031 exchange to be completely tax-free. Any boot received is taxable to the extent of gain realized on the exchange. In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100% tax free. The difference is called “Boot,” which is the amount you will have to pay capital gains taxes on. This option is completely okay, and often used when a seller wants to make some cash, and is willing to pay some taxes to do so.
An example of this would be if your original property is sold for $2,000,000 and the property you wish to exchange under section 1031 is worth $1,500,000, you would need to pay the normal capital gains tax on the $500,000 “boot.”
The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and title holder that buys the new property. However, as an exception to this rule occurs in the case of a single member limited liability company (“smllc”), which is considered a pass-through to the member. Therefore, the smllc may sell the original property, and that sole member may purchase the new property in their individual name.
For example, the single member of “Sally Jones LLC” is Sally Jones. The LLC can sell the property owned by the LLC, and because Sally Jones is the sole member of the LLC, he can purchase property in his name, and be in compliance with the 1031 code.
The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind. This can be really difficult because the deals still need to make sense from a cash perspective. This is true especially in today’s market because people tend to overprice their properties when there are low-interest rates, so finding all the properties you need can be a challenge.
An exception to this is known as the 200% rule. In this situation, you can identify four or more properties as long as the value of those four combined does not exceed 200% of the value of the property sold.
To qualify under a 1031 exchange it’s necessary that the replacement property be received and the exchange completed no later than 180 days after the sale of the exchanged property OR the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier.
As you might realize, there are many rules and qualification requirements that you must comply with in order to perform a successful 1031 exchange. To sum things up, the biggest advantages of a 1031 exchange is that you can avoid having to pay capital gains taxes on the sale of an investment property. This can be a huge benefit for real estate investors who know which markets are primed to grow next. It can also be a huge downfall for beginning investors, or those who don’t understand the changing real estate landscape. If you don’t you risk falling victim to one the biggest disadvantages of a 1031 exchange–the reduced basis for depreciation on the replacement property.
This means that if you were to sell your replacement property, even at a deficit, you would still be accountable for the capital gains on the initial property. In other words, if you want to maximize the benefits of your exchange, it’s important that you choose your replacement property (or properties) wisely, investing in a market that has good potential for growth in the future.
At it’s core, a like-kind exchange (also called a 1031 exchange or starker exchange) is executed for one reason: to defer taxes. What many people don’t realize is that it can do so much more than this.
At Real Wealth Network, we advise our members to exchange their high-value investment property for turn-key, cash flowing, investment properties in the strongest U.S. markets. We do this to help them leverage their tax-savings to invest in properties that will (a) generate more cash flow every month, (b) take less time to manage, and (c) give them more freedom.
Here’s an example:
“My favorite [like-kind exchange] success stories was when a woman named Jill came to our office in mid-2007 and told us she had 3 properties in Stockton, California worth about $400,000 each. She said they were very old and in need of repair, and each brought in about $1200 per month in rent. Jill really wanted to quit her job and retire but she didn’t think she could live on the net income from those properties, which was about $2400/month (net refers to the remaining cash flow once expenses are paid.)
I was very happy to be able to look Jill in the eyes and say, ‘I’ve got great news for you. You can actually retire today.’
I explained that she could exchange her three old, dilapidated California properties in very rough neighborhoods for nine brand new Texas properties in highly desirable areas.
Here’s how the numbers would look: She owned the 3 Stockton properties free & clear. They would sell at that time for about $400,000 each. Thanks to Section 1031 of the US tax code, she could exchange those properties tax-deferred for 1.2 million dollars worth of property in Texas.
The average home price in Dallas, Texas was $122,000 at the time so finding 9 high-quality properties for under $130,000 each would be easy. And even more surprising was that those properties would easily rent for $1200 each.
Remember, Jill was getting $1200 rent on just three properties in California, and those homes were in total disrepair. Maintenance and repair costs were eating up the cash flow.
Fortunately, Jill listened to me and took the leap, and the results were astounding. She sold the Stockton homes and I helped her exchange them for nine really lovely Dallas properties. I also helped her put all those properties under excellent property management, so she no longer had to suffer as a typical landlord fixing toilets.
Her gross income went from $3600/month to $10,800/month and her net income went from effectively zero (due to the old homes requiring so much repair) to $6500 in monthly net income. Plus, the homes she bought in Texas were brand new and would require little or no repair for years.”– Excerpt from Kathy Fettke’s (Real Wealth Network Co-Founder and Co-CEO) book Retire Rich With Rentals.
We had a house in San Francisco. It was a rental property, and we knew we wanted to sell it. But if we did sell it, we would have to pay a pretty hefty capital gains tax. So, we knew we had to do a 1031 exchange. Do you have any idea how many 1031 exchange rules there are? It’s insane. We were looking at making about $1.5 million, but there was no way we could buy “like-kind property” in the Bay area, and actually make a profit. That’s when we heard Kathy Fettke on the radio, and what she was saying sounded too good to be true. It really did.
We were very cautious when we first found Real Wealth Network, so we took our time. But eventually we trusted them. Their whole ideology is about teach you how to be a great investor, and it really works. I mean, I’ve learned so much more in the last year or so than I ever knew about rental property before.
It was amazing how much father our money went outside of the Bay Area. I know the old rule of thumb was, “You have to be around your rentals.” But with technology, the internet, and a trustworthy team, this isn’t necessarily true anymore. At least it wasn’t true for us.
The result: We sold the one property in Bay area and using a 1031 exchange we turned around and invested in about 20 properties, increasing our cash flow six times Claudia & Julian Fraser
Are you inspired now? Hopefully the answer is yes by now. Why?
Because everyone has the ability to end up with passive income from real estate – even if you don’t have any money to start with. All you need is the education to know how to do a 1031 exchange correctly — understand the rules, develop a strategy, and find the help you need to get the deal done right.
This article is just a basic overview of how to do a 1031 exchange in 2017. Hopefully, you now realize how important it is to understand the intricacies of real estate investing, real estate market cycles, and growth opportunities before you even think about attempting a 1031 exchange. If you’re a beginner, you should start by learning how and where to invest in real estate in 2017. For those of you who are more experienced, take some time to get a solid understanding of 1031 exchange rules–you need to know them like the back of your hand, or you still might end up with a huge tax bill.
Truth be told, a 1031 tax-deferment is incredibly complicated, even for career investors. Even a small mistake can jeopardize the deferment of your capital gains taxes, which is why most investors seek professional help.
If you need any help at all, let us know. We can give you referrals to excellent self-directed IRA companies, 1031 exchange facilitators, and world-class CPAs that specialize in real estate tax.
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