A 1031 exchange is a tax planning strategy that allows investors to sell an existing property and defer the payment of capital gains taxes and other transaction-related costs
Generally, Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”), provides an alternative strategy for deferring the capital gains tax that may arise from the sale of a property. By exchanging a relinquished property for “like-kind” real estate, as defined below, property owners may defer their federal taxes and use all of the proceeds for the purchase of replacement property.
Whether any particular transaction will qualify under Section 1031 depends on the specific facts involved, including, without limitation: the nature and use of the relinquished property and the method of its disposition; the use of a “qualified intermediary” and a qualified exchange escrow, as discussed below; and the lapse of time between the sale of the relinquished property and the identification and acquisition of the replacement property.
DO NOT MISS YOUR IDENTIFICATION AND EXCHANGE DEADLINES!
Failure to identify a replacement property within the 45-day identification period or failure to acquire replacement property within the 180-day exchange period will disqualify the entire exchange, resulting in a fully taxable original property.
THREE BASIC RULES TO QUALIFY FOR COMPLETE TAX DEFERRAL:
Receive only “like-kind” replacement property
Use all proceeds from the relinquished property for purchasing the replacement property.
Make sure the debt on the replacement property is equal to or greater than the debt on the relinquished property. (Exception: A reduction in debt can be offset with additional cash; however, a reduction in equity cannot be offset by increasing debt.)
IRS regulation requires a Qualified Intermediary to properly complete an exchange. A QI, also referred to as an Accommodator or Facilitator, is an entity that facilitates Internal Revenue Code Section 1031 tax-deferred exchanges. A QI Enters into a written agreement with the taxpayer (the exchange agreement) under which the qualified intermediary:
Acquires the relinquished property from the taxpayer;
Transfers the relinquished property to the buyer;
Acquires the replacement property from the seller;
Transfers the replacement property to the taxpayer.
Do not try doing a 1031 exchange using your attorney or CPA to hold funds. We can help connect you with a trustworthy QI near you.
Below are some examples of “like-kind” real estate:
Commercial property, including commercial rental property
30-year or more leasehold interest
Farm property (but not farm equipment)
Residential rental property
Doctor’s own office
A tenant-in-common ownership interest in an investment property. Tenant-in-common, or “TIC,” ownership is ownership of commercial real estate that has been split into fractional shares. Each owner owns an undivided fee interest in the property equal to his proportionate share of the real estate.
A beneficial Interest in a Delaware statutory trust, or “DST.”
It is important to note that one’s primary residence, as well as vacation or second homes held primarily for personal use, will not qualify for a Section 1031 exchange. However, there are certain safe harbors for vacation and second homes to qualify as either a “relinquished property” or a “replacement property.”
Though DSTs and REITs are both passive investments and focused on real property buy-ins, they are not alike. Here’s how they differ:
REITs differ in structure — While a DST is a legal entity (established by the state of Delaware as a trust), a REIT is an organization with the goal of acquiring, managing and selling real estate, REITs have been known to hold hundreds of assets at one time. A DST, in comparison, is usually a single asset or a small portfolio of properties.
Company shares versus property shares —An investment in a REIT gives you a share of the company that is buying/managing/selling the asset, rather than actual real property ownership.
Minimum investments —REITs have much lower minimum investments (comparably $1,000 versus $100,000), fee structures and investment objectives.
Different tax benefits —While taxable income derived from a DST investment may be written off through interest and depreciation deductions, dividends distributed by REITs cannot, since a REIT investment is not considered a direct interest in real estate.
A DST investment is an investment in real estate; any investment in real estate is subject to market value and rental income fluctuations, tenant issues, vacancies, taxes, and governmental regulations. There are costs and fees associated with a DST investment and management and the tax benefits must be weighed against the investment costs.
A DST owner does not maintain management control or dictate day-to-day property management operations. DST ownership is also subject to additional IRS regulations that affect the management of the property and your ownership interest. Investors should investigate and thoroughly understand these issues prior to investing in a DST offering.
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