Posted by The TaxAdvocate Group, LLC

Like-Kind Exchange Rules and Definitions for Investors

Like-Kind Exchange Rules and Definitions for Investors

The 1031 Exchange, alias Like-Kind Exchange or Starker Exchange, is a powerful tax deferral strategy used by some of the most successful real estate financial investors. This may be even more true for 2020. Why? Because real estate prices in many American cities passed "bubble levels" ten years ago. For this reason, many investors believe that today is the perfect time to change ownership in expensive markets, with properties flowing in cash across the country.

If you want to learn how to conduct a deferred tax transaction, there is no better time than now. In this comprehensive article, you'll find answers to five of the most frequently asked questions by investors.

You will learn the definition of a 1031 exchange, the 1031 exchange rules, the types of exchanges, and the benefits of performing a 1031 exchange.

 

What is a 1031 exchange?

The term 1031 exchange is defined in section 1031 of the IRS Code. This strategy allows an investor to "defer" the payment of capital gains tax on a real estate investment when it is sold, provided that another "similar property" is acquired with the proceeds from the sale of the first property. We will discuss similar properties in more detail in the fourth section.

According to experts, a stronger stock market can allow a real estate investor to change their investment direction without incurring tax obligations. For example, you can invest in properties that are low income and therefore require a lot of maintenance. You can trade-in your high maintenance investment for a low maintenance investment without paying large taxes. Or you can move your investments from one place to another without calling the IRS, and 1031 makes this possible.

 

Note: Conventionally, a 1031 exchange is where one property is exchanged for another property of the same type. But, the likelihood that the property you desire to be owned by someone who does is very unlikely. This is why the vast majority of negotiations are delayed; they are tripartite or Starker (named after the first tax process that authorized them). In a late transaction, you need a broker to secure your money after you "sell" your property and use it to "buy" the replacement property for you. This tripartite exchange is treated as an exchange.


When to do a 1031 Exchange?

When you sell a real estate investment, even if you didn't originally buy it, you end up having to pay capital gains tax. If you made the wrong investment or were unlucky, selling your investment may cost you more than what you earn.

But if you own a rental property that's worth a lot more today than you bought it, you can make money with this powerful strategy.

The big question: how do you use this strategy?

 

Four types of real estate exchanges

There are four main types of similar exchanges for investors to choose from. The most common similar exchanges include simultaneous, delayed, reverse, and construction or updated exchanges.


Simultaneous Exchange: This exchange occurs when the replacement good and the returned goods are closed on the same day. As the name suggests, these closings take place simultaneously. It is important to remember that the exchange must take place simultaneously; any delay, even a small delay caused by transferring money to an escrow company, may result in disqualification from the exchange and immediate application of the full tax.

There are three basic ways in which simultaneous trading can take place:

  • Exchanges or performs a transaction between two parties, whereby the two parties exchange or "trade" securities.

  • Tripartite exchange in which a "compatible party" is used to facilitate the exchanger's transaction simultaneously.

  • Simultaneous exchange with a qualified agent who structures the entire exchange. 




Delayed Exchange

A different change from a similar rate, which is the most common type of exchange chosen by investors today, occurs when the exchanger leaves the original property before purchasing the replacement property.

In other words, the property owned by the fellow (which is called "transferred" property) is transferred first, and the property that the fellow wishes to exchange (the "replacement" property) is acquired next.

The exchanger is responsible for selling your property, securing a buyer's guarantee, and fulfilling a purchase contract before the delayed exchange can begin. Once this has happened, the broker must hire an external broker to initiate the sale of the transferred asset and keep the sale's proceeds in a binding trust for a maximum period of 180 days while the seller buys similar assets.

With this strategy, the investor has a maximum of 45 days to identify the replacement property and 180 days to finalize his property's sale. Besides the many tax benefits, this extended period is one reason why late trading is so popular.


Reverse Exchange

A 1031 reverse exchange, also known as currency exchange, occurs when you buy a replacement property through a stock exchange owner before changing the property you currently own. In theory, this type of trade is very simple: first, buy, then negotiate.

What complicates reverse trading is that it requires all the money. Additionally, many banks do not offer reverse business loans. Taxpayers must also decide which of their real estate investments will be purchased and which will be "parked." If the transferred business is not closed within the 180-day period in which the purchased business is parked, the right to negotiate expires.

Reverse trading follows many of the same rules as deferred trading. However, there are a few important differences to keep in mind:

  • Taxpayers have 45 days to identify the property that will be sold as "transferred property."

  • After the first 45 days, taxpayers have 135 days to complete the identified asset's sale and close the 1031 reverse exchange with the replacement asset's purchase.


Improvement or Construction Exchange

The improvement or construction exchange allows taxpayers to make improvements to the replacement property using exchange capital. Simply put, the taxpayer can use their deferred dollar to improve the replacement property while still being placed in the hands of a qualified broker for the remainder of the 180 days.

It is essential to note that the taxpayer must also meet three conditions if he wishes to defer any profits (from the sale of the returned goods) and use them instead as part of the exchange of buildings or improvements.

  • All amendment capital must be spent on completed improvements or as a prepayment on the 180th day.

  • The taxpayer should receive "substantially the same products" that he identified on the 45th day.

  • The replacement asset must have equal or greater value when returned to the taxpayer. 

Improvements must be implemented before the taxpayer can regain the title of a qualified intermediary.


A Summary of 1031 Exchange Rules 

There are several rules and qualification requirements that you must follow to be successful in a transaction. In short, the biggest benefit of using this strategy is that you can avoid paying capital gains taxes to sell a real estate investment. This can be of great benefit to real estate investors who know which markets are going to grow. It can also be a big drop for first-time investors or those who don't understand the real estate landscape changes. Otherwise, you risk falling victim to one of the biggest drawbacks: the reduced depreciation base of replacement assets.

This means that if you sold your replacement property, you would still be liable for the capital gains on the original property, even with a deficit. Conversely, if you want to maximize the profits from your trade, it is important to choose the replacement good wisely by investing in a market with good potential for growth in the future.


Conclusion:

Everyone has a chance to earn a passive real estate income, even if they don't have the money to start. All you need is solid training on how to use this powerful strategy properly.

This article is only a basic overview of how the like-kind exchange works. We hope you now realize how important it is to understand the complexity of real estate investing, the real estate market cycles, and growth opportunities before you even think about it to begin. If you are starting, you should start by understanding how and where to invest in real estate. For those who are more experienced, take the time to gain a solid understanding of the rules and regulations. You have to know them like the back of your hand, or you may end up with a huge tax account.

To be sure, a 1031 tax deferral is incredibly complicated, even if you are a professional investor. Even a small mistake can compromise the deferral of capital gains tax. This is why most investors seek professional help.


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