Nine out of 10 US millionaires have found tremendous financial success in real estate investment. Read the seven reasons why 90% of millionaires choose to invest in real estate and why you should too in this article.
The federal government’s rules and regulations offer favorable incentives including annual depreciation and interest expense deductions. These tax deductions encourage investors to deploy money into real estate. The most favorable, generational wealth building tool can be found in Section 1031 of the IRS code. According to IRS.gov,
Whenever you sell a business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.
A 1031 exchange allows a real estate seller to defer paying taxes so he or she can leverage capital gains into a larger asset with presumably greater cash flow. The IRS essentially allows an investor to ‘kick the can down the road’ and reinvest the government’s money via a 0% interest loan. The taxes do not disappear, but an investor has the opportunity to leverage the government’s money into larger assets. The 1031 program rewards investors while encouraging further investment in real estate.
This is one of the greatest wealth building tools that exists, because there is no limit on the number of times an investor can utilize a 1031 tax exchange. The federal government is also flexible on the definition of a like kind property. For example, you can sell an apartment building and purchase an office building, land, industrial building, or an asset in a different sector of real estate. To qualify for a 1031 like-kind tax exchange, there are important rules and regulations that must be met. Identification timeframe and the process are two key items to understand.
The government offers two primary identification methods for a 1031 exchange. Both methods require the seller to utilize an intermediary to quarterback the process. Some intermediaries specialize in only 1031 transactions. Other investors choose to utilize their preferred real estate attorney, whose firm is capable of handling a 1031 transaction. To execute a 1031, it is imperative the exchanger (seller of relinquished property) hire an intermediary who handles the 1031 transaction, before the relinquished property closes. A 1031 is considered null and void if the seller (of the relinquished property) takes position of the funds from the relinquished asset sale. More information about the top ten identification rules for a 1031 exchange can be found here.
The traditional 1031 method allows for a 45-day requirement to identify and designate property to purchase, once the relinquished property has sold. There are two “identifying” rules that govern how many properties can be identified. The first rule allows an exchanger to identify up to three properties to purchase. The second method allows an exchanger to identify as many properties as desired, up to 200 percent of the value of the relinquished asset. The second timeframe rule pertains to total days to purchase the replacement asset(s). From the sale of the relinquished asset (property sold), you have 180 days to finalize a transaction to purchase a replacement property or properties.
The second method to execute a 1031 occurs when the exchanger buys “replacement assets” before the relinquished property is sold. A reverse 1031, as implied, is effectively the reverse order of a traditional 1031. This option takes more time and is more cumbersome from a paperwork/process standpoint. The replacement asset(s) are purchased first and held by an intermediary. Then, the 1031 applicant has 180 days to close on the asset. Why would anyone utilize a reverse 1031? Black Diamond Realty recently experienced a situation, whereby a client secured a purchaser for a parcel of land and the client wished to defer capital gains tax payment. So, the client secured two replacement properties via a purchase and sale agreement. The land contract needed to be extended multiple times. After six months, the seller of the replacement assets (our client was the buyer) applied pressure for the multifamily properties to sell immediately. In addition, our client wanted to close on those assets, because we were in a rising-interest-rate environment. Our client closed on the two multifamily “replacement assets” before finalizing the sale of his land (cause for the capital gain to be in play), resulting in a reverse 1031 being executed.
Black Diamond Realty recommends you consult with your accountant or tax advisor and a real estate attorney before finalizing your like-kind exchange strategy. BDR has many on-market and off-market replacement opportunities. So, please utilize our team as a resource. Wealth building tools have been created to incentivize folks to invest in real estate. Be aware of their availability and utilize them to meet your investment goals.
Article written by:
David Lorenze, Principal