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1031 Exchanges: What They Can Do for Small Investors
By Mesa Foard, Carolina Homes & Interiors
Want thousands more dollars to put into your next investment? How would you like to buy an investment property close to the beach? Maybe you've always dreamed about buying a business but your capital is tied up in non-income producing investment property. With I.R.S. Code Section 1031, also known as the Starker Exchange, you can cleverly make your long-term investment goals come true.
So just what is a 1031 Exchange and why is it valuable to you? In general, a 1031 Exchange allows for the tax-deferred exchange of any business-use or investment property for "like kind" property of equal or greater value. What that means to you is that your capital gains taxes are postponed if you reinvest the proceeds from the sale of one investment property into another within the guidelines of the code. Yet many investors sell a property that has significantly appreciated, put the proceeds in the bank and then buy another investment property, paying hefty sums in capital gains taxes and depreciation. Had they used a 1031 Exchange, they could have actually increased their investment leverage.
"Everyone sees the tax benefits of 401Ks and IRAs where you can put money away tax-free and that money will increase," said Margo McDonnell, President and COO of 1031 Corp., Inc.
The same holds true for 1031 Exchanges.
"If you don't think about what a 1031 Exchange will do for you long-term, you are missing the boat. I have a client who sold many smaller properties through different exchanges for $800,000 and bought $2,000,000 worth of property. He saved half a million dollars in taxes," said Ms. McDonnell. "The more you think about this, the more powerful it is."
With a 1031 Tax Exchange, you can buy other investment property with pre-tax dollars. You sell your current investment, known as the "relinquished property," and place the proceeds in escrow with a "qualified intermediary," or independent middleman. You then identify and acquire a "like kind" property. This property is known as the "replacement property."
The beauty of the 1031 Exchange is that you're not locked into swapping out one investment for a clone of the one you currently own. "Like kind property has a broad and liberal definition," said Ms. McDonnell.
Unimproved land can be exchanged for income-producing rental property; an unproductive farm can be exchanged for an office building. And, if done properly, an investment property can even be exchanged for your future dream retirement home, generating rental income in the meantime.
Personal-use property, vacation homes, stocks, bonds and other exclusions as specified by the code do not qualify. But you can do non-real estate items so long as they are truly like kind, i.e., within the same asset class or SIC code, such as furniture, fixtures, equipment — even planes. You can also do a "multi-asset exchange" where non-real estate items and property are both included, such as with a restaurant.
The strategy for using 1031 Exchanges is to make better investments. That means you can combine several smaller investments into a large one, receive higher income from a new investment, relocate a business, find an investment property that requires less work to manage, trade up to a more valuable investment, etc.
A 1031 Exchange can even be an important estate planning strategy since the tax liability is forgiven upon the death of the investor, leaving heirs with a stepped-up basis in the property. "If you plan properly, you will never have to repay capital gains taxes," said Ms. McDonnell.
But if you sell your investment and pocket the proceeds before buying a new one, not only will you have to pay capital gains taxes, depreciation is recaptured, as well. And, your income taxes may jump. "Investors don't realize when they sell property that they will be bumped into a higher tax bracket," said Ms. McDonnell.
As powerful as it is, a 1031 Exchange is not without drawbacks. You cannot have access to or control over the sale proceeds, which are held in escrow by the qualified intermediary. The cost basis of the relinquished property becomes the basis for the new one. You also cannot immediately resell the replacement property.
Strict time limitations apply under the regulations, requiring you to identify a new investment property within 45 days of a sale and to close the sale of the replacement property within 180 days to avoid paying taxes — with no extensions if you fail to meet the deadlines. Plus, if you need to sell the replacement property within the time limitations specified by the code, you may have to pay taxes sooner than expected.
The key to making it all work to your advantage is proper planning.
"It's important to talk to a tax advisor who understands your situation," said Ms. McDonnell. Legal counsel may also be necessary.
Since qualified intermediaries are not regulated, be sure to do your homework when choosing one to assist you. Carefully read your contract and understand how the qualified intermediary will hold and protect your money. Some pay interest while others don't. Fees that seem low may mean you're not earning any interest on your escrow. You should also ask for a third party guarantee from the qualified intermediary's parent company.
"Just be sure to compare apples to apples," advises Ms. McDonnell.
The Federation of Exchange Accommodators (FEA) is the only national trade organization for qualified intermediaries and policies in the industry. Certified Exchange Specialists must pass an exam and get continuing education while adhering to the organization's code of ethics. Listings of FEA members can be found online at www.1031.org.
Although the 1031 Exchange has been around since 1921, people are finally finding out about it. "They've grown tremendously on the East Coast, and every year they get more and more popular," said Ms. McDonnell.
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