1031 Exchange for Commercial Property
First of all, what's a 1031 exchange? A 1031 exchange is a like-kind exchange or a Starker exchange. It is a tax-deferment technique that is used by some financially successful real estate investors. Due to recent activities, it has become optimal to exchange properties through a 1031 exchange to gain cash flowing properties in many U.S. cities.
What is a 1031 Exchange?
1031 exchange is defined under IRS Code Section 1031 as a strategy that allows investors to defer payment on an investment property's capital gain taxes once it's sold. This is as long as another like-kind property is bought and acquired with the gained profit of the first property's sale.
1031 exchange, traditionally, is where one property is exchanged for another property of a like-kind. However, it becomes more and more unlikely for you to get the exact property that you want to be swapped from another prospective exchanger. This is why most 1031 exchanges for commercial property are either delayed or have three parties. In a delayed exchange, you will require the expertise of a middle man to hold on to the cash after you have sold your property and use it to buy a replacement property in exchange. This exchange is treated as a swap between both parties, while the three parties there act as the middle man.
When To Do a 1031 Exchange?
· When you sell an investment property. This is because you may end up having to pay tax on whatever capital gain you get and this doesn't matter if you were the initial purchaser or not.
· When you've made bad investment decisions or having a stream of bad luck while selling your investment.
If you find yourself in either of those shoes, then it's safe to say that you need to do a 1031 property exchange before any decisions cost you more than you profit. This is when you can tell yourself that a 1031 exchange is a good idea.
Now, how do you use the 1031 exchange successfully? Here's how to do a 1031 exchange;
Doing a 1031 Exchange
To do a 1031 property exchange successfully, you must exchange an investment property for another of similar value. This process will mean that you have to avoid capital gains for a while as you focus on the exchange. A 1031 exchange for commercial property would be the same thing as like-kind property exchange.
Usually, an investor would cash out all capital gains and pay taxes on it but in this case, you will have to trade properties to defer off all tax obligations. This makes 1032 an important tool for investors in the real estate industry. The exchange rules have a special requirement that the new loan amount and the purchase price on the replacement property are either the same or higher. For example, if you were selling a million dollars property in San Francisco that already has a loan of $340,000, you would have to buy the million dollars or more of replacement property with $340,000 or more as leverage.
4 Types of Real Estate Exchanges
There are four main types of like-kind exchanges that you can choose from. Remember that choosing the type of exchange can be difficult like setting up WIFI in your garage door opener. It is always best to look for professional help in these situations. From the delayed and simultaneous exchanges to the improvement or construction and reversed exchanges, here are the types of real estate exchanges.
A simultaneous exchange is carried out when a relinquished and replacement property close on the same day. The closing, as the name implies, is done simultaneously. The keynote there's is simultaneous, which means that a slight delay in wiring money to the escrow company may and can result in the exchange being disqualified and the application of full capital gain taxes immediately.
There are three major ways to conduct a simultaneous exchange;
· The first way is to complete or swap a two-party trade, in which both parties swap or exchange their deeds.
· The second is a three-party exchange, in which an accommodating party, middleman, is used to carry out the transaction in a simultaneous manner for the exchanger.
· The third is with the aid of a qualified intermediary who maps out the entire exchange.
This is the most common type of 1031 exchange as it occurs when the exchanger sells off the original investment property before acquiring the replacement property. In this case, the exchanger who owns the relinquished property primarily sells off the property before acquiring the property he wishes to exchange it for.
Being in charge of his property, the exchanger is solely responsible for the following; marketing the property, securing a buyer for it, executing the sale, and executing a purchase agreement before initiating the delayed exchange. Once this has been carried out, he then hires a third-party intermediary to begin the sale of the relinquished property and then afterward, hold the sales proceeds in a binding trust for 180 days till the seller can exchange it for like-kind property.
This strategy helps an investor maximize 45 days for the identification of a replacement property and 180 days for the completion of the property sale. Apart from the tax benefits, the extended time frame has also made the delayed exchange a popular choice.
A reverse 1031 exchange, happens when a replacement property is acquired through an exchange "accommodation" titleholder before the exchanges are carried out. It's also known as a forward exchange as you buy first and then, exchange later.
The tricky part of this exchange is that it is all cash. You may not be offered loans for reverse exchanges and as a taxpayer, you have to decide which investment is going to be purchased and which ones are going to be parked. During the 180 days period when the acquired property is parked, failure to close on the relinquished property will result in an exchange forfeiture.
While there are some similarities between the reverse exchange and the delayed exchange, some rules differ:
· There's a period of 45 days for the taxpayers to identify the property that is going to be on sale as the relinquished property.
· Once the initial 45 days, the remaining 135 days are to be used to complete the identified property and to finalize the reserve 1031 exchange with the acquisition of the replacement property.
Construction or Improvement Exchange
The construction or improvement exchange allows taxpayers to make improvements on the acquired property by using something called exchange equity. This means that taxpayers can use their money to enhance a replacement property while it is still in the hands of a qualified intermediary for the duration of the 180 days.
However, taxpayers must meet all three requirements to defer all capital gains and use it as an improvement exchange. These requirements are that;
· all the exchange equity must go into improving the replacement property or are to be used as a down payment on the final day,
· you must receive a like-kind property as identified by the 45th day, and
· the replacement property must be either the same or higher in value when the deed is returned back to you. Before the taxpayer retakes the deed from the intermediary, all improvements must have been carried out and in place.
There you have it, all you need to know about 1031 exchange for commercial property. If you need further assistance with anything tech related, like using chrome in offline mode, visit our blog for more answers.