Maybe you’ve heard of a 1031 Exchange or simply a 1031. A term that got its name from the IRS Code section 1031, it is an exchange or a swap of one property for another that is a powerful tax strategy allowing for the deferral of capital gains taxes.
Anyone who owns real estate can harness the power of the 1031 exchange. Just by following this process, you can replace your property and buy a replacement investment, while deferring tax payment on what you gain from the sale.
Want to know how you can have more cash flow through this investment? Or want to earn passive income without being pummeled by taxes?
In this article, you will find key points regarding the 1031 Exchange – rules and concepts you should know if you are thinking about any kind of real estate investment, and when using the 1031 Exchange to invest in a real estate syndication.
A Better Return on Investment
This exchange into syndication helps you by offering a better return on investment while giving you an increase in cash flow. Therefore, when you exchange it with a larger and more valuable property via syndication, the benefits increase twofold.
With this exchange, you get the ability to buy like-kind property while deferring capital gains taxes. If you continue re-investing into other properties, doing this exchange until your death, the investment will be handed down to the heirs, and the cost of the property will reset to the current investment value allowing you and your heirs to avoid the capital gains tax.
However, if you sell the property and take the proceeds (without reinvesting), you will have to pay the capital gains.
Timeline to Execute the 1031 Exchange
The IRS has a specific time frame in which the 1031 exchange needs to be executed, and it needs to be followed for the exchange to run smoothly.
You have 45 days to identify the asset that you will be acquiring, starting from the day of the sale of your existing asset. The IRS does not allow you to access the funds or to touch the property once you sell it. It is also a requirement that you engage a qualified accommodator to facilitate the transaction.
Once you have identified your next asset, the IRS gives you a further window of time so that you can close on the asset. This means that you have a total of 180 days from the day you complete the sale of the original asset to the closing of your next asset. The IRS has strict rules and a timeline to follow and if you are unable to follow those rules you will have to pay the capital gains.
The Role of Accommodator
The role of the accommodator (a qualified intermediary) is to facilitate the process of the transaction from the sale of your asset to the closing of your next asset.
The intermediary helps you walk through the entire process and steps required for the syndication and makes sure that you never miss the timeline, which is outlined by the IRS. In doing so they will help you avoid a taxable event.
The accommodator you hire must be an independent entity and should not be related to you.
Once you hire the accommodator, you will have to enter agreements, including an Escrow Account Agreement, Like-Kind Exchange Agreement, and others that will allow the intermediary to act on your behalf through the transaction process.
Identification Rules for Next Property
There are some rules set by the IRS that you can use to identify the replacement properties. You must choose to follow at least one of these options.
These rules are:
The 3-property rule
Investors, most of the time, use the 3-property rule to identify up to three properties that might generate more cash flow. This means you can exchange into one or all the replacement properties.
If you want to identify more than three replacement properties, you will have to use the 200% fair market value rule.
200% fair market value rule
What is that? How does it work?
Let us give you an example.
Suppose you sell your property for $2,000,000, and identify up to 3 replacement properties for exchange.
You can identify a fourth or fifth replacement property as long as the sum total value of all the properties combined does not exceed $4,000,000 or twice your property’s selling price.
95% Exception Rule
The 95% Rule allows for you to identify any number of replacement property options, regardless of valuation, provided that you follow through and actually acquire a property or properties that equate to at least 95% of the identified value within the exchange period.
For example if you sell your property for $2,000,000 and then identify more than three properties worth $10,000,000 to exchange into, that is allowed if you actually end up spending at least $9,500,000 or 95% of the identified value within the exchange period.
Can I 1031 Exchange my Residential or Vacation Home?
Your primary residence or vacation home is not qualified for this type of exchange. However, there is an exemption, which is known as Section 121. This is a complicated structure, and you will need to take qualified advice to make sure that the exchange is properly executed.
1031 Exchange is a technique for investors who want to earn passive income from real estate. You need a clear understanding of the process so as to leverage it correctly. The procedure can be complicated and that’s why most investors prefer to work with experienced partners.
Our aim is to help you grow your wealth. We are here to help you with the 1031 exchange so that you can enjoy the benefits that apartment syndication provides.