A 1031 Exchange, also called a Starker Exchange, is a powerful tax-deferment strategy used by some of the most financially successful investors. This is, perhaps, even truer in 2017, where prices in many U.S. cities have surpassed the “bubble levels” of a decade year ago. Because of this, many real estate investors think that 2017 is the optimal time to exchange properties in expensive markets for cash-flow properties across the country.
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.
An A1031 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. A 1031 makes this possible.
What 1031 Exchange rules must I follow?
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.
Rule 1: Like-Kind Property
Exchanging an apartment building for a duplex would be allowed.
Exchanging a single family rental property for a commercial office building would be allowed
Exchanging a rental property or vacation rental for a restaurant space would be allowed.
Rule 2: Investment or Business Property Only
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.
If you moved from California to Georgia, you could not exchange your primary residence in California for another primary residence in Georgia.
If you were to get married and move into the home of your partner, you could note exchange your current primary residence for a vacation property.If you were to own a single-family rental property in Idaho, you could exchange it for a commercial rental property in Texas.
Rule 3: Greater or Equal Value
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.)
Rule 4: Must Not Receive “Boot”
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 information explained here was obtained from the Real wealth Network. There are many different companies that deal with 1031 Exchanges. For more information email or call us today so that we can answer any questions you may have.