Byron Smith Sr. has been investing in real estate for nearly 40 years, building wealth by using a 1031 exchange to defer taxes and acquire better, more profitable properties.
A recent exchange of a single-family property in northern Virginia for one with more growth potential in Richmond would have resulted in about $60,000 in state and federal capital gains taxes — that is, had the Vienna, Virginia-based attorney and real estate broker not enlisted the help of a qualified intermediary to transfer the equity from one investment to another under the popular IRS provision.
“The theory of a 1031 exchange is a continuity of investment liquidity. If you don’t sell the investment and cash out, you’re not really liquidating. You’re merely changing your type of investment,” says Scott Saunders, senior vice president of Asset Preservation in Colorado Springs, Colorado, which conducts 1031 exchanges for clients. “It gives you purchasing power throughout your lifetime.”
[See: 10 Long-Term Investing Strategies That Work.]
A 1031 exchange, which is also used to trade up collectibles, art and business equipment, can be a smart estate planning tool, says Nancy Grekin, principal of the Honolulu real estate firm Grekin Law. An investor who owns property, whether in the individual’s name or through a limited liability corporation, can offer a stepped-up cost basis to heirs, allowing them to sell it tax-free if the total estate is worth less than $5.5 million.
But before using a 1031 exchange, investors should consider the rules.
The exchange must be of “like kind.” Under IRS rules, an investor must exchange a property for a similar one, which must be held for investment and not put up for sale. That means you can sell one rental to buy another rental, but not sell a rental to buy a property you plan to flip, Saunders says. You also can’t sell a property to purchase stocks or collectibles, because they’re not the same kind of investment.
You need a qualified intermediary. The IRS also dictates that a 1031 exchange must be conducted by a qualified intermediary, who handles the transaction’s paperwork and reporting requirements. Because the investor cannot touch the funds, the intermediary holds proceeds from a sale in an escrow account and applies them to a new property. An intermediary costs about $750 to $1,250 nationally, Saunders says.
The federal government doesn’t regulate intermediaries, though some states do. An intermediary will be holding a large sum of your money, so choose one carefully after due diligence, Smith says.
“Investigate how they hold the funds and how they distribute them,” Saunders says. “You want it in a separate account and not co-mingled.”
If a company goes bankrupt while holding your money, you cannot touch it, so avoid smaller and potentially more unstable outfits, Grekin says.
The industry’s trade association, the Federation of Exchange Accommodators, lists qualified professionals on its website.
[See: The 10 Best Ways to Buy Real Estate.]
There’s a deadline. Once you close on the sale of your property, you have 45 days to identify, in writing with the intermediary, up to three new properties you’d like to purchase. The value of the new property or properties must be equal to or greater than the property being sold, Saunders says. Then you have 135 days to close on the property.
It’s also possible to do a reverse exchange, in which you can purchase your new property before you sell the old one, but only if you’ve got the cash for the purchase. That money is later paid back to you through the intermediary after the old property is sold.
Some investors may find the timeline for a 1031 exchange too constraining, particularly because identifying a new property in a hot market could force them into an undesirable purchase, Smith says.
“In a market like today when there is a limited amount of inventory and prices are very high, the investor has to really plan well in advance.”
Other demands. Although it’s possible for an owner to take some cash from a 1031 transaction, the money will be taxed. About 30 percent of every real estate 1031 transaction results in some taxation, says Steve Chacon, vice president of exchange service operations for Denver-based intermediary Accruit.
You’ll also need to be diligent about reporting property income on your taxes. A property that you held for investment through a 1031 exchange but didn’t claim income on is likely to attract scrutiny from the IRS, Grekin says.
[See: The 10 Best REIT ETFs on the Market.]
Still, “for seasoned real estate investors, it’s a tool,” Smith says. “The end goal is to try to continue to build wealth.”
More from U.S. News
A 14-Point Checklist for Land Investing
9 Investing Myths That People Still Believe
13 Ways to Take the Emotions Out of Investing
This Is How a 1031 Exchange Helps You Build Wealth originally appeared on usnews.com
