The 1031 Exchange: The Good and The Bad side of Like-Kind Property Exchange

1031 exchange

Relationship Banking has become more vogue than ever before, especially after the financial crisis. Even though many banks have turned towards commodity services which reduce differences among competitors, financial institutions which focuses upon long term relationship with customers to provide them valuable services seems to be more successful in future.

The concept behind 1031 Exchange- one property owner sells any property to acquire another one without paying capital gain taxes incurred during the transaction- is technically designed and relationship-oriented as the present actions impact future investment returns of investors i.e. the clients. The tax-free Exchanges listed under Section 1031 of the U.S. is based on their origin in the Revenue Act of 1921.1.

Defining 1031 Exchange in Simpler Form

The 1031 Exchange is one term that every property buyer and seller must have come through in the U.S.. This Like-Kind Exchange allows investors to sell their Investment Property, defer capital profits and recapture depreciation taxes that could trigger on their entire sale if the seller party agrees to utilize their sale proceedings to purchase another property of greater or equal value.

The taxes can reach up to 37.5% in your real estate capital gains. 1031 Exchange can be applied to any property which is not your primary residence or it can be applied to those residential properties that have a home office, business, or Airbnb. Some various rules and guidelines need to be followed before opening an exchange.

Basic steps involved in the 1031 Exchange

Even though 1031 Exchange are commonly used for business purpose, they prove very helpful for real estate investors. To complete the 1031 Exchange, 7 step process is required generally. For any professional, completing the below-mentioned steps might take lesser time as compared to other people since it is a complicated procedure.

The below section will give you a glimpse of the 7 basic steps of 1031 Exchange:

1 Investment Property selling

2 Engage a Qualified Intermediary to share capital gains

3 Finding a Like-Kind Property in between 45 days from the date of listing

4 Forwarding a duty letter to Qualified Intermediary

5 Making negotiations with the Like-Kind Property seller and agree upon sales price

6 Having intermediary wire the capital profits to the host company or the titleholder

7 Filling IRS Form 8824

The purpose behind listing in 1031 Exchange

Professional real estate investors follow the strategy of making purchases and holding the property. But, with a growing portfolio, it might become impossible for you to make any payments for paying the principal amount through rent collection and mortgages. The cash-flowing asset which can be controlled contributes towards your portfolio growth and will perform by mitigating the risks of building a non-performing property. This means, selling property makes sense only if the sale proceedings allow you to make more purchases to grow a profitable portfolio.

However, selling a property to use the capital flow for a growing portfolio can prove very expensive. It may require you to pay real estate commissions, title fees, inspections and most importantly capital gains tax which is 37.5%!

This is where the 1031 Exchange acts as a tool for real estate investors.

The exchange allows investors to sell their property without compensating capital gains that maximises the equity amount which can be further used for purchasing larger property and helps in accelerating the portfolio growth.

Example to give the concept a clear picture

To make you understand the exchange concept more clearly, let us take an example where you can assume yourself as a real estate investor purchasing a residential property for $50k. Currently, you came to know that the property has become $100 k worth and will give you $50K capital gains if sold now.

Knowing the rules of the 1031 Exchange, you start looking for Like-Kind property to match with your capital gains and defer capital gain taxes, state taxes sometimes and depreciation recapture.

At first, you need to look for a real estate agent who will sell your property for $100K during which you need to find Like-Kind property to make purchases.

Next, you need to work with a Qualified Intermediary who can be found by making a search over the database of Federation of Exchange Accommodations or through a local Escrow Officer.

Now, within 45 days you need to find another property and forward the same to your Qualified Intermediary with a signed duty notice. Once this letter gets submitted, only the properties included in the list becomes eligible for using the exchange.

For instance, your agent finds you a property worth $150K, the remaining $100K will then need to be financed by additional equity. Hence, the entire 1031 Exchange gets completed, deferring $50K capital gains and $5K of capital gains taxes.

Here it can be noted that the intermediary does not report anything in front of the IRS, however, IRS may audit you for which you need all your documents verified by the intermediary for compiling them successfully under IRC section 1031.

The good behind 1031 Exchange

  • From the taxation point of view, it can prove substantial for investors.
  • Investors can involve 1031 exchange for acquiring those properties even which are appreciating faster than Relinquished ones and simultaneously purchase many properties that are equally proportionate to the sale property value.
  • At present Rock-scissor-paper world in the real estate industry, 1031 Exchange enables decision analysis and tax-saving to fulfil the primary moto of leveraging transactions successfully.
  • MarketLine psychology comes forward in the decision-making process as 1031 Exchange adds a tickling clock in the entire exchange process.

Bad behind 1031 Exchange

  • Since the entire procedure entails investors relinquishing and reinvesting at least two properties, many investors roll capital gains more than once and thus banking customers relationships becomes very significant while making 1031 Exchange decisions.
  • Any inexperienced investor might get ripped due to over-inflation of property value or due to the acquisition of unsuitable property for safeguarding capital gains.
  • Although minimising taxes becomes the primary goal of every investor, the relationship between financial institutions must not be ignored especially while making partnerships with customers.
  • The overall process although might seem simple in papers, it proves very complicated in the real world.

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