What is a 1031 Exchange?
If, as an example, you may be considering the sale of real estate held for investment, and you sell or exchange such business or investment property and make a profit, you generally must pay capital gains taxes.
The Internal Revenue Code (IRC) offers you one of the most significant tax planning strategies to help preserve and potentially grow your investment portfolio. Through a transaction called a 1031 Exchange, you can defer the capital gains taxes that may arise from the sale of real estate.
A 1031 Exchange allows you to sell your real estate property, re-invest the proceeds in “like-kind” real estate, and defer payment of taxes on that sale. The Internal Revenue Service (IRS) defines like-kind as property that is similar in nature or character, regardless of differences in grade, property type or quality. There is a range of potential benefits, including deferral of capital gains. For Investors, a 1031 Exchange may also provide an effective tax strategy for tax deferral as part of succession and estate planning.
The Internal Revenue Code Section 1031 provides that “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for of the like kind which is to be held either for productive use in a trade or business or for investment.”
1031 Exchanges provide an effective strategy for deferring the capital gains tax that may arise from the sale of your business/investment property. By exchanging the property for like-kind real estate, property owners may defer their tax and potentially use all of the sale proceeds for the purchase of replacement property. Like-kind real estate includes business/investment property, but excludes any personal-use property.
Like-Kind Properties
Under Section 1031 of the Internal Revenue Code
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Commonly referred to as a “like-kind exchange”
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Allows for the complete deferral of all federal and state taxes on relinquished property
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Seller of a relinquished property must re-invest sale proceeds into a “like-kind” property
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Can exchange any type of real estate for any other type of real estate (personal property does not qualify)
The gain that would have been recognized in a taxable sale is deferred until the replacement property is sold in a taxable transaction.
In most deferred exchanges, taxpayers engage a “qualified intermediary” (QI) to prepare an exchange agreement and hold the net sales proceeds from the relinquished property in an exchange escrow account, pending acquisition of the replacement property.
Taxpayers may structure a series of exchanges, compounding the benefits of tax deferral, thereby building wealth over time.
The taxpayer may exchange real property for any other real property located in the United States or its possessions for productive use in a trade or business or for investment.
Please note – Taxable boot:
Any cash or “non-like-kind” property received in the exchange is taxable.
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“Like-kind” refers to the nature or character of the property and not its grade or quality.
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Real property can be improved or unimproved (land), which means taxpayers may exchange unimproved real estate for improved real estate and vice versa.
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Generally, all real property is “like-kind” to all other real property.
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Personal property is not “like-kind.”
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The exchanger’s intent must be to hold the replacement property for investment or use in a trade or business.
Debt secured by relinquished property must be offset by equal or greater debt secured by replacement property (reduction of debt may be offset by cash from another source).
Examples of like-kind properties:
Air Rights
Apartment Buildings
Condominiums
Development Rights
DST Interests
Duplexes/Triplexes
Easements
Hotels/Motels
Industrial Property
Leasehold Interests (Thirty years or less remaining)
Mineral Rights
Office Buildings
Retail Centers
Rental Resort Property
Single Family Rentals
TIC Interests
Vacant Land
Water Rights
Warehouses
Step 1
Sell your property; proceeds are escrowed with a Qualified Intermediary (QI).
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Day
1
Step 2
Identify a property within forty-five (45) days
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Day
45
Step 3
Close on your new property within one hundred eighty (180) days of the sale of the relinquished property.
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Day
180
Exchange Qualifications
In addition to timing considerations, a qualifying exchange requires you to:
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Re-invest all equity
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Purchase a replacement property of equal or greater value
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Obtain equal or greater amount of debt on replacement property
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Failure to satisfy these requirements will create a tax liability.
180-Day Timeline
In order to complete a 1031 Exchange successfully and defer your capital gains liability, you must follow strict requirements over a 180-day timeline.
Delaware Statutory Trusts (DSTs)
Considering the use of a DST in order to complete your 1031 Exchange.
In most cases, 1031 Exchanges are completed by the investment property owner utilizing the help of a real estate broker; however, there is another alternative – a passive way to conform to the regulations of a 1031 Exchange – and that is a Delaware Statutory Trust (DST).
With its unique organizing structure, a DST can offer you many benefits:
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Access to institutional-quality real estate
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Professional asset and property management
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Passive Ownership
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Non-recourse institutional financing
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Lower minimum investments
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Portfolio diversification
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Ability to close quickly
Investors in a DST are not direct owners of the real estate.
DSTs that are organized effectively are recognized by the IRS as qualified replacement property for real property. The trust holds title to the property, for the benefit of many investors, each of whom has a “beneficial interest” and is treated as owning an undivided fractional intertest in the property.
DSTs provide a “turn-key solution” for investors who may not have the time, energy or real estate expertise to find and/or manage a replacement property. DSTs can be used for all or a portion of sales proceeds; however, you should be aware there may be fees or expenses associated with a DST.
There are guidelines that DSTs must follow. Specifically, a DST may not:
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Invest accrued cash, from rental income or investment proceeds, between distributions in anything other than short-term securities.
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Accept additional capital to the DST.
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Re-negotiate terms of debt or enter into new financing.
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Re-negotiate leases.
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Enter into new leases (except in certain circumstances).
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Make improvements other than minor non-structural repairs.
All investments in a DST involve certain risks, including the potential lack of return, loss of principal and tax consequences. The performance of a DST will depend on the tenants’ ability to pay rent. Properties may be leveraged, and will be liquidated at the discretion of the DST, which may encounter difficulty in selling any or all of them. No public market exists, nor is likely to develop for the DST interests.
Why a 1031 Exchange?
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Defer federal and state taxes (does not forgive taxes, tax will be paid if later sold in a taxable transaction)
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Diversify to attempt to reduce risk by acquiring several replacement properties
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Taxpayers may structure a series of exchanges to compound the benefits of tax deferral, thereby potentially building wealth over time
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Acquire higher quality replacement property than a taxpayer can afford on their own
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Seek to build family wealth over time with multiple exchanges
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Potential tax forgiveness for heirs with a step-up in basis upon death
- Potential tax forgiveness for heirs with a step-up in basis upon death
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Exchange non-income producing property (for example, land) for income-producing property (for example, multifamily)
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Exchange actively-managed property (for example, a rental house) for passive property (for example, DST)
Offering Disclosure
The contents of this communication: (i) do not constitute an offer of securities or a solicitation of an offer to buy securities, (ii) offers can be made only by the confidential Private Placement Memorandum (the “PPM”) which is available upon request, (iii) do not and cannot replace the PPM and is qualified in its entirety by the PPM, and (iv) may not be relied upon in making an investment decision related to any investment offering by an issuer, or any affiliate, or partner thereof ("Issuer"). All potential investors must read the PPM and no person may invest without acknowledging receipt and complete review of the PPM. With respect to any “targeted” goals and performance levels outlined herein, these do not constitute a promise of performance, nor is there any assurance that the investment objectives of any program will be attained. All investments carry the risk of loss of some or all of the principal invested. These “targeted” factors are based upon reasonable assumptions more fully outlined in the Offering Documents/ PPM for the respective offering. Consult the PPM for investment conditions, risk factors, minimum requirements, fees and expenses and other pertinent information with respect to any investment. These investment opportunities have not been registered under the Securities Act of 1933 and are being offered pursuant to an exemption therefrom and from applicable state securities laws. All offerings are intended only for accredited investors unless otherwise specified. Past performance are no guarantee of future results. All information is subject to change. You should always consult a tax professional prior to investing. Investment offerings and investment decisions may only be made on the basis of a confidential private placement memorandum issued by Issuer, or one of its partner/issuers. Issuer does not warrant the accuracy or completeness of the information contained herein. Thank you for your cooperation.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
● There is no guarantee that any strategy will be successful or achieve investment objectives;
● Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
● Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
● Potential for foreclosure – All financed real estate investments have potential for foreclosure;
● Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
● Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
● Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits