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What You Should Know About 1031 Exchanges And How They Work

Updated: Jun 29, 2021

Do you own or have you inherited an investment property? Does renting the property and becoming a landlord seem unappealing to you? You could consider the option of selling the property, but you may become subject to significant capital gains taxes.

Well, there is another alternative for you. A 1031 exchange is a real estate transaction that allows you to receive passive income from an investment property without becoming a landlord. Read on to find out just what this option is all about, and how Sequoia Equities may be able to help.

What is a 1031 exchange?

A 1031 exchange refers to a type of transaction where an owner of an investment property swaps it with another property, thereby taking advantage of rolling over capital gains tax.

The term 1031 exchange stems from Section 1031 of the US Internal Revenue Code, which describes the set of rules pertaining to this type of exchange transaction. People who own real estate are subject to capital gains tax once the property is sold. Exercising the right to 1031 exchange, however, will not give rise to an immediate capital gains tax, but will roll it over onto the new property, which resulted from the exchange. But just as with any property deal, this exchange has its own set of rules and regulations.

Basic rules of a 1031 exchange

All property tax legislations comprise a complex set of rules. Here are the most basic and key regulations that you should know about a 1031 exchange:

Like-kind property:

The IRS will only allow a 1031 exchange between properties, which it deems to be of a like kind. This means that not all properties can be swapped together within the frames of a 1031 exchange. However, the rules are not excessively strict, and you can even exchange a business for another business.

45 and 180-day rules:

The 45 and 180-day rules are set to limit the time frame within which a 1031 exchange transaction should take place and reach its close.

45-day rule

This first rule sets a time limit between selling an investment property and submitting the decision specifying which replacement property the investor would like to purchase.

180-day rule

This second timing rule sets a time limit on closing the deal and purchasing the replacement property.

1031 exchanges will require the services of an intermediary, either an attorney or third-party advisor (TPA), that will facilitate the exchange of property for the investors. The proceeds of the initial sale are received by the intermediary and retained until the replacement property is purchased.

The 1031 exchange is only intended for business and investment property, i.e. property that is used for earning income and not residence purposes. However, the rules can apply to a former primary residence as well, under certain conditions.

Why is a 1031 exchange so beneficial?

First and foremost, the primary benefit of this type of deal is to defer capital gains tax. The exchange gives an opportunity to temporarily freeze the tax on capital gains that would have been applicable in the case of a sale. After the exchange, the tax is said to be rolled over until the replaced property is sold in the future, if it ever is. There is no limit on how many times an individual can make a 1031 exchange, meaning that properties can be replaced indefinitely, so capital gains will also constantly be rolled over.

Another benefit of engaging in this type of transaction is avoiding depreciation recapture. Most investment properties are depreciable, meaning that their initial cost is spread out as expenditures of wear and tear throughout the useful life of this asset. Individuals may be required to “recapture” the written-off depreciation upon the sale of the property, if it is sold for higher than the depreciated amount at the time of sale. Since the 1031 exchange does not assume that the property is being sold, the depreciation recapture can be avoided.

Using 1031 exchanges to pursue passive real estate investments

“Tenancy in common” (TIC) is another variation of the 1031 exchange concept. It allows investors to own a portion of a large investment property along with a maximum of 34 other individuals and/or businesses, while retaining equal rights.

People who engage in this type of transaction are allowed to trade their share of the property as they wish, without the permission of other owners. TIC enables the benefit of becoming a landlord without managing the property. Investors are effectively earning passive income with virtually no work to do. This is also an excellent way to diversify investments into smaller portions or to own a share in a desired large asset.

Estate Planning with 1031 Exchange

One of the key takeaways from this article is that 1031 Section of the US Internal Revenue Code provides plenty of opportunities from which you can benefit with the right planning.

Not only can you defer capital gains taxes by swapping properties indefinitely, but you can also do a huge favor to your heirs who shall inherit your property. Within the scope of 1031 exchange, heirs can inherit a 1031 exchanged property from their predecessors on a stepped-up basis, thus avoiding inheritance taxes.

So, by engaging in a 1031 exchange, there are individual benefits for you, but there are also perks for your heirs. Tenancy in common arrangements can also be used to conveniently distribute properties to be inherited after death.

Sequoia Equities is here to help!

Here at Sequoia Equities, we specialize in multifamily investment opportunities in apartment communities, which are distinct by design with amenities, services and a multitude of resident perks.

For over 30 years, Sequoia has been helping investors to structure 1031 exchange deals to help you reap the benefits of multifamily real estate investing. Sequoia Equities offers consistent deal flow, making it easier for investors to find a suitable 1031 exchange opportunity within the restricted time frame. We are always ready to assist clients who are interested in 1031 exchanges, so contact us today to get started.

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