By: James McGurren, CPA, CFP®
Investment property is a key component of many high-net-worth individuals’ portfolios. One potential downside, however, is that you may be faced with significant tax implications when you decide to sell property.
Fortunately, there’s a strategy that could enable you to defer this tax liability. Known as a 1031 exchange, this technique allows you to defer these taxes if you reinvest the proceeds from the property’s sale into another qualifying piece of investment property.
What is a 1031 Exchange?
When business or investment property is sold at a gain, capital gains tax usually must be paid by the seller at the time of the sale. These taxes can be substantial on property that has appreciated significantly in value. For example, the total tax on the sale of property that has appreciated by $2 million could be as high as $400,000, assuming a capital gains tax rate of 20%.
Section 1031 of the Internal Revenue Code (IRC) provides an exception for what is referred to as “like-kind exchanges.” This exception allows investors and businesses to defer paying capital gains taxes if the proceeds from the sale are reinvested in similar (or like-kind) property within a certain timeframe.
Note that capital gains realized in a 1031 exchange are tax-deferred, not tax-free. This means that the taxes will eventually have to be paid.
The Basic Steps to a 1031 Exchange
The first step in performing a 1031 exchange is to identify which property you want to sell. Ideally, this should be property you have owned for a long time (generally at least 5 years) that has appreciated significantly in value.
The next step is to identify a like-kind property to purchase in its place. According to IRC Section 1031, any real estate held for investment or productive use in a trade or business may be exchanged for any other real estate also held for investment or productive use in a trade or business. So, an apartment building could be exchanged for office property, for example, or office property could be exchanged for retail property.
While the exchange of properties in a 1031 exchange does not have to be simultaneous, specific timelines must be met for the exchange to benefit from tax deferral. First, a potential replacement property must be identified within 45 days of selling the original relinquished property. You will need to write a description of the replacement property and deliver this to the seller or qualified intermediary. The role of the intermediary is an important one, you may want to consider working with a title company or consulting with an attorney who has experience with 1031 exchanges.
Second, the replacement property must be closed on and the exchange completed within 180 days of the sale of the relinquished property, or the income tax return due date for the tax year in which the relinquished property was sold, whichever is earlier.
Types of 1031 Exchanges
There are three main types of 1031 exchanges:
Simultaneous 1031 Exchange
As the name implies, this is when the selling and buying of the like-kind property occurs simultaneously. This is the ideal scenario, but sometimes investors are ready to sell property they own but haven’t yet identified a replacement property. Other times sellers may have found replacement property they are interested in purchasing but haven’t yet identified a property they want to sell. In these scenarios, one of the following types of exchanges will be used.
Delayed 1031 Exchange
With a delayed exchange, you will transfer your original property to a qualified intermediary who will subsequently sell the property and purchase a like-kind replacement at a later date (according to the timelines noted above). The replacement property would then be transferred to you.
Reverse 1031 Exchange
With a reverse exchange, the qualified intermediary will purchase the replacement property now and you can decide what you want to sell as replacement property later (according to the timelines noted above).
Peter Simon’s Perspective
Careful and thoughtful planning is the cornerstone of a smooth and successful exchange. From identifying the right property to orchestrating the transition, strategic planning maximizes the potential for long-term financial gains.
Peter Simon, Founding Partner of Simon Quick reflects on his personal experience:
"Having personally navigated 1031 exchanges involving a residential property back in 1988—one that remains in place to this day—I empathize with the initial apprehension surrounding these transactions. Despite the specific rules and procedures that must be adhered to in selecting assets before executing the transaction, with thoughtful planning, what might appear complex can unfold seamlessly. 1031 exchanges continue to yield long-term gains for my family." – J. Peter Simon, Founding Partner
Do Primary Residences Qualify?
Some types of property are excluded from use in 1031 exchanges. This includes personal use property, such as a primary residence or second home. However, income-producing property does qualify for a 1031 exchange, including single- and multi-family homes that you rent out. Thus, converting a second home into a rental property could qualify use for a 1031 exchange so long as it has it consistently been a rental property for some time.
Work with a Trusted Advisor
1031 exchanges can be very attractive to property owners, but careful attention should be paid when implementing one. It is important to follow all the guidelines in section 1031 of the tax code – IRS regulators are known to scrutinize these exchanges.
Furthermore, remember that when you execute a 1031 exchange, you are acquiring a new property. You should be confident that the property you are acquiring is of good quality. The tax benefits of the exchange won’t be worth it if you aren’t happy with your real estate purchase in the long run.
A 1031 exchange could be a beneficial strategy for you and your family, but keep in mind that this technique is complicated and requires expert assistance. You should consult with professional advisors, including tax and estate planning professionals and your wealth advisor, for guidance in your specific case.
Simon Quick can help you determine if executing a 1031 exchange makes sense for you. Visit us online, call us at (973) 525-1000 or send an email to firstname.lastname@example.org to discuss your specific situation.
About James McGurren, CPA, CFP®
Managing Director / Client Advisor / Principal
Jim is a Managing Director and Client Advisor at Simon Quick Advisors. Simon Quick is a growing multi-family office wealth management firm and has been providing customized financial planning and investment consulting solutions for wealthy individuals and families since 2004.
As a Certified Public Accountant and CERTIFIED FINANCIAL PLANNER® professional, Jim has a highly personalized approach to client relationships. His background includes more than 25 years of experience in public accounting, with special emphasis on tax and financial planning for the wealthy. Jim’s career has spanned the financial services industry, including disciplines such as investment management, financial planning, taxation, accounting, litigation support and corporate advisory services. This experience gives him the breadth of knowledge needed to lead a team of professionals that can provide the individuals and families we serve with world-class service.
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