Building Wealth Utilizing 1031 Exchange
March 01, 2023
What is a 1031 Exchange?
1031 exchange is considered a swap or like-kind exchange. A real estate investor will sell one investment property (or multiple properties), take the money from the sale, and purchase another investment property or multiple properties while deferring payment of taxes. Real estate investors cannot use the proceeds from the sale of the property to purchase stocks, bonds, company vehicles, or tangible personal property. If you take money out of the sale of the investment property (called "boot"), you will be taxed.
Investment Time Frame and Considerations
Understanding the timing of 1031 exchanges is crucial. The clock starts ticking on the day of the original property's sale. You have 45 days to identify another property (or properties) to invest in and 180 days from the original sale date to close on the new investment property (or properties). Miss these deadlines, and you will be paying the taxes.
Another critical consideration is that you cannot downsize from your original investment.
What are the options with a 1031 Exchange?
Depending on your circumstances, timing, and financial goals, you can work with your CPA to successfully structure the transaction and defer payment of taxes. There are four options to consider:
- Simultaneous Exchange. This is the oldest method of conducting a 1031 exchange where both the sale of the original investment property and the purchase of the new investment property happen at the same time.
- Delayed exchange. The sale of the investment property and purchase of the new investment property or multiple properties happen within the mandated 180-day time frame.
- Delayed reverse exchange. The new investment property is purchased before the original investment property is sold.
- Delayed build-to-suit exchange, or 'build-to-suit exchange. The money received from selling the original investment property is deposited with a qualified intermediary. This option allows the investor to build new or renovate the property. The investor must identify the property they intend to purchase within 45 days and include a description of what will be built on it.
A client of ours sold their investment property and received $3 million that was sent from escrow to a qualified intermediary. The client had 180 days to find and acquire a new investment property. The choices presented to them were:
- Purchasing a business complex valued at $3 million.
- Purchasing an apartment building valued at $2 million.
- Purchasing a multi-family home valued at $1 million.
Working with the client, their options were:
- Buy the business complex for $3 million and defer all taxable gains.
- Buy the business complex AND the apartment building for a total of $5 million. This option would defer the $2 million taxable gains and take out a loan for a $3 million split between the two properties.
- Buy the apartment building for $2 million AND the multi-family home for $1 million and defer the taxable gains on the total purchase of $3 million.
What if you can't find another investment?
Investors who can't find a replacement property have an additional option called a Delaware Statutory Trust (DST). Take the example above. Suppose our client could not find a property or decided he wanted to take a hands-off approach to reinvest his $3 million money. In that case, he could invest in a qualified DST and defer the tax gain.
How Long Can I Continue to Defer My Taxes?
With the help of a knowledgeable CPA and your estate planner, you can plan to leave your real estate investments to your heirs. If your heirs choose to sell the property upon your passing, they will receive the current market value for the property with limited or no taxable gains exposure.
It's Not Complicated with the Right Partner
Are 1031 exchanges complicated? Yes, but they don't have to be! We look at your overall portfolio to ensure you are structuring the 1031 exchange to receive the most significant tax benefit according to your wishes. You will need to understand several rules and timeframes and how you structure the transaction. The Cambaliza McGee team will work with you to understand your goals and financial needs to ensure you are structuring the exchange to take full advantage of the tax laws.