This article is for educational purposes. 1031 exchanges have restrictions and limitations.
When the time comes to sell your real estate, some owners of highly appreciated real estate could be staring at a substantial capital-gains tax bill. A section of the Tax Code may help you convert your appreciated property into an income stream while deferring up to 100% of the capital-gains tax that would otherwise be due on the sale.
This transaction, known as a '1031 exchange,' is named for a section of the Internal Revenue Code that authorizes this exchange. With a 1031 exchange, you can dispose of an investment property without paying an immediate capital-gains tax (or triggering a depreciation recapture tax) if the entire proceeds are used to purchase full or partial interests in 'like-kind' properties as defined by the IRS code.
The current capital-gains tax savings could be substantial. In addition to the federally imposed capital-gains tax of 15%, any gain on the sale of a property could otherwise be subject to state income tax. That means your total tax bill could run as much as 20% or higher.
In addition to the tax deferral, 1031 exchanges may provide real estate owners with an opportunity to help improve their lifestyles -for example, by exchanging a highly management-intensive property for one or more properties that are less demanding to manage. These transactions can be beneficial to real estate owners with appreciated properties that make up 5% to 50% of their net worth.
Reduced Stress and a Higher Level of Potential Income
It sounds simple enough, but with the Tax Code, there is always a hitch. In this case, the IRS has set out a long, stringent set of guidelines that define qualified transactions. But the principal issue is that proceeds from the sale of one property must be reinvested in a 'like-kind' replacement property within a certain amount of time to avoid taking that tax hit. These properties don't have to represent a one-for-one swap.
Investors can use the sale from one property to buy tenant-in-common, or TIC, interests in a variety of different properties, opening up an opportunity for strategic planning. For instance, investors who prefer to take a less active role in real estate management can trade a high-maintenance portfolio of rental properties for hands-off interests in other commercial ventures.
Through what's known as a TIC transaction, you can reinvest the proceeds of those exchanges into a non-management, fractional interest in a larger commercial property. You get a share in the rental income without having to assume any responsibility for the day-today management of the property.
This option is particularly attractive for investors looking to boost income potential. The 1031 exchange may end up generating a higher level of income for the property owner than they had earned on the previous property. More importantly, you may be able to have a more diversified real estate portfolio than you might have had to begin with.
For instance, consider the case of a real estate owner who plans to reinvest the proceeds from a $5-million property into a $3-million property. The owner also plans to distribute the remaining $2-million in proceeds from the exchange across a variety of TIC investments. With the exchange of a single $2-million property, the owner could invest in as many as eight different TIC properties, assuming a standard $250,000-minimum investment in each TIC transaction.
Putting the 'Estate' in Estate Planning
TIC exchanges may have the ability to be customized to fit into a real estate strategy. For instance, you may be able to increase your cash flow by exchanging a piece of raw land and investing in one or more income-producing properties. Or you could possibly decrease your current tax liability by exchanging a fully depreciated property and using those gains to buy more leveraged property, thereby increasing your depreciation expenses.
TIC exchanges may be a particularly important part of an estate plan in which the primary asset is a single piece of property:for instance, a family farm that future generations don't want to maintain. The owner can exchange that land and then divvy that money up into several smaller properties. After the owner's death, each heir will inherit their own piece of property that they can manage as they see fit. And with the death of the owner, the heirs receive a one-time step-up in cost basis, effectively erasing the deferred tax liability.
As with any valuable asset, managing the exchange of real estate tax efficiently is a complex undertaking. But with a 1031 exchange you may be able to diversify your holdings without any current capital gains tax liability.
A 1031 Exchange is available to accredited investors only. ($200,000 yearly income and $1,000,000 net worth). A 1031 exchange may be subject to special risks including illiquidity. A 1031 prospective investor should consult with their own legal, tax, accounting and financial advisor before investing as tax advantages may be lost if not executed within established time constraints. A 1031 exchange prospective investor should carefully consider the charges, expenses and risks of a 1031 exchange and whether it is appropriate for them based on their financial situation, objectives and time constraints.
Any discussion pertaining to taxes in this communication (including attachments) may be part of a promotion or marketing effort. As provided for in government regulations, advice (if any) related to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code. Individuals should seek advice based upon their own particular circumstances from an independent tax advisor.
In conjunction with Sagemark Consulting, a division of Lincoln Financial Advisors, a registered investment advisor