On a recent episode of our People, Not Titles podcast, host Stephen Kaempf talks with Anna Barsky, VP of IPX1031’s bustling Chicago office and an expert in 1031 exchange rules and regulations.
She’s been working in this industry for over 15 years and was the main presenter of Landtrust’s 1031 Exchange Webinar for Real Estate Professionals and Investors, where she shared invaluable insights about this type of transaction and the benefits for both your clients and your business.
Let’s take a closer look at the machinery behind a 1031 exchange and how to leverage this process to enhance your spectrum of services.
It’s a Smart Money Move
Section 1031 of the United States Internal Revenue Code allows buyers to defer paying taxes on the sale of an investment property by quickly purchasing another of like kind and equal or greater value within a certain time frame. Anna states that it’s “sometimes seen as the last tax loophole for real estate investors.”
Sometimes referred to as a “like-kind exchange,” this process defers capital gains tax, applicable state taxes, the 3.8% Medicare surtax on investment income, and depreciation recapture.
In her example, a person purchases an apartment building for $500K and sells it three years later for $700K. Of course, Uncle Sam wants his cut of the investor’s $200K profit, but if they turn around and buy one or more investment properties totaling $700K or more, then that tax burden is kicked down the road. Anna puts it simply as “sale + purchase = no tax payment.”
She also points out that real estate investors who don’t utilize a 1031 exchange could end up paying between 28% to 35% taxes on the profit of any investment property sale.
There are non-tax reasons for this process as well:
- Increasing the investor’s purchasing power
- Diversification, consolidation, or expansion of a real estate portfolio
- Estate planning, aka, “Swap Until You Drop”
Clients are able to build an impressive portfolio relatively quickly because they can instantly re-invest the funds that would’ve been eaten up with taxes and move up the ladder to bigger and better properties.
Since all investment properties are like-kind, there’s quite a bit of flexibility — you could exchange a residential rental for a more profitable industrial building, or trade a retail space for vacant land. Farmland and mineral, air, oil, and gas rights can be exchanged as well.
What’s not included? Cash, stocks, bonds, certificates of trust, or the investor’s primary residence do not qualify, nor do vacation or second homes that aren’t rented out at all. House flippers and developers will also not be able to use this tax loophole, as the IRS considers this inventory rather than investment real estate.
It’s ideal for those who are tired of managing rental real estate like single-family homes and would rather invest in hands-off assets such as a triple net lease (NNN) property or a DST (Delaware Statutory Trust) product.
For estate planning purposes, 1031 exchanges enable a person’s beneficiaries to receive a step up in basis. This is when the price of an inherited asset on the date of the decedent’s death is above its original purchase price, which minimizes capital gains taxes for your heirs if or when the property is sold, and your beneficiaries are able to avoid all those taxes the original investor deferred.
If you’re working with a client who wants to sell an investment property, ask how they’ve been dealing with their tax liability. Offer to do a conference call with their accountant or financial planner to explore whether a 1031 exchange would provide the maximum benefit.
Real estate brokers should advise their clients that “step number one is to always check in with your CPA,” says Anna, and then get an attorney involved to handle the extensive documentation.
Getting everyone in alignment as early as possible and ready to execute is key due to the timeline requirements of 45 days to identify the new investment property and 180 days to complete the exchange. Planning ahead is crucial, as scrambling at the last minute could derail the process. If the sale of the investment property is closed, it’s too late to do a 1031.
For those interested in exchanging for a property that could later be converted to a primary residence, there is definitely a way to do that, Anna emphasizes, as long as you follow the rules. The property must be used for rental purposes for the first 2 years, and there’s a 5 year holding period requirement in total.
The most important thing to remember in a 1031 exchange is that you need to act quickly and work with skilled and knowledgeable professionals who fully understand the rules and deadlines. The IRS also requires that an investor has to hire a third party to handle the actual exchange, as the taxpayer is not allowed to actually receive any funds during the process or own both the relinquished property and the replacement at the same time.
Taxpayer continuity must be maintained, but there’s some flexibility as to who holds the title. An investor could sell a property in their name and buy the replacement property as a single-member LLC, a revocable trust in which they’re the trustee, or as a beneficiary of a land trust.
Your 1031 Resource
The main takeaway from Anna’s incredibly informative discussion is that if you’re a real estate agent who’s working with a client with an investment property, you should talk about a 1031 exchange as early as possible.
Secondly, advise the owner to consult with their CPA and real estate attorney to determine if an exchange makes sense for their circumstances and that they receive the full tax deferral benefits that they’re entitled to.
Last, keep in mind that 1031 exchanges with multiple properties or reverse and improvement components can become extremely complex, which is why it’s critical to work with a partner who has a deep expertise in this area, like Anna’s team at IPX1031 and Landtrust Title Services.
If you have any questions about a 1031 exchange or you’re ready to sell your investment property and take advantage of this beneficial process, reach out today to schedule a consultation.