The 1031 Exchange
A 1031 exchange is a powerful tool for property investors and business owners. So, how does it work? A property owner can sell an investment property, roll the proceeds over into a replacement property, and there is no immediate tax consequence for the transaction. All capital gain taxes that are associated with the sale are deferred.
Misconceptions to Avoid
The 1031 exchange, while straightforward, carries many misconceptions by the public. Here are the top 3 in 2022:
1. Vacation and Second Homes Qualify
I can sell my investment property and use a 1031 Exchange to buy a beach house.
MAYBE
You can sell your investment real estate and reinvest 100% of the gain, tax deferred, to purchase a different property. The kicker is making sure that the property will qualify under the 1031 investment rules. The first 2 years of ownership carry strict guidelines on personal use. You may only use your property for 14 days or 10% of the days that you rent it out. (If you rent your property for 300 days, you may use it for 30 days.) This rule only applies for the first 2 years, after that time period expires, the home is yours to use as you wish. We recommend speaking with a trusted tax advisor before you make a decision.
2. Reinvesting Proceeds
I only have to reinvest the gain from the sale of my former property to fully defer my taxes.
FALSE
To defer the full amount of tax, you have to reinvest the entire amount of equity from the sale of your property into the replacement. The replacement property must be equal or greater in value. If you keep some of the equity you will only have a partially deferred tax amount. You will be responsible for paying taxes on the amount of funds not reinvested. Keep in mind while you need to replace the VALUE of the debt paid off on the Relinquished Property, the debt does not need to be replaced with debt. The exchanger can bring their own additional cash to the table.
3. Replacement Property Improvements
I closed on my Replacement Property and I want to use funds from my exchange to improve the property and increase its value.
FALSE
You may not use a Delayed 1031 Exchange to make property improvements on a replacement property. If you want to make improvements to a property, plan ahead. You can leverage an Improvement Exchange or a Build-to-Suit. IPX-1031, takes title through a separate entity while you finish the improvements. Once it is complete the property transfers to you. This program is structured differently and adds cost to the exchange.
Where do I start?
Seeking a trusted Qualified Intermediary is your first step. This might be a real estate attorney, a CPA specializing in 1031 exchanges, or a bank. Find someone you trust with experience and knowledge. Their guidance is key to a successful transaction.
Speak to your tax advisor who will offer additional guidance.
We at H3 Property Management are always ready and willing to help in any way we can. If you are a tenant looking for a long term rental or a real estate investor looking for a high quality tenant, let us know! Contact us at www.H3PM.com or 406-209-3335.