Compound Your ROI With The 1031 Exchange

Are you a real estate investor looking to increase your return on investment (ROI)? A 1031 exchange may be the answer.

A 1031 exchange, a like-kind exchange, is a tax deferment strategy that allows investors to swap out an investment property for another and defer capital gains or losses. Instead of paying taxes on the sale of your property, you can reinvest the proceeds into another property and continue to compound your ROI.

At our Royal Investing Summit, Dan McCabe, Co-founder and President of Exchange Resource Group, shares his 40 years of experience in handling 1031 exchanges and how they work as an investment strategy.

In this blog post, we'll discuss what a 1031 exchange is, how it works, and what rules you need to follow to take advantage of this powerful tax deferment strategy.

How Do You Defer Capital Gains Tax With A 1031 Exchange?

When selling an investment property, a 1031 exchange allows you to defer capital gains tax by reinvesting the proceeds into a similar type of property:

Exchange your investment property for another "like-kind" property.
The exchange must be completed within 180 days of the sale of the original property.
You must identify potential replacement properties within 45 days of the sale.
You must close on the replacement property within 180 days of the sale.
Any profits from the sale are deferred until you sell or dispose of your new investment property.

What Are The Rules And Regulations For a 1031 Exchange?

A 1031 exchange, a like-kind exchange, is a tax deferment strategy that allows investors to swap one investment property for another and defer capital gains taxes.

Here are the rules and regulations of a 1031 exchange:

The replacement property must be of equal or greater value than the sold property.
The exchanged properties must be of "like-kind," meaning they must be similar in nature or character.
The purchase price of the Replacement Property must equal or exceed the selling price of the Relinquished Property.
You must identify a replacement property for the assets sold within 45 days.
You must conclude the exchange within 180 days.
You may take some money out to use any way you like, but you will be liable for paying the capital gains tax on that amount.

Imaginative Ways To Use A 1031 Exchange

There are more imaginative ways to use a 1031 exchange than a traditional one.

Reverse 1031 exchanges, Reverse Improvement Exchanges, and Reverse Construction Exchanges are all viable options that can help you maximize your gains while minimizing your taxes.

Reverse 1031 Exchange

A Reverse 1031 Exchange is a tax deferment strategy that allows real estate investors to trade one investment property for another without incurring capital gains.

Here are important points to consider when looking into a Reverse 1031 Exchange:

The replacement property must be purchased before the relinquished property is sold.
The investor can only take actual possession of the replacement property after the relinquished property is sold.
The exchange must involve like-kind properties, which must be held for investment or business use.
A qualified intermediary facilitates the exchange.
There are strict timelines for the exchange to qualify for tax deferment.

Reverse Improvement Exchange

A reverse improvement exchange is an advanced exchange that allows taxpayers to acquire their intended replacement property before selling their current property.

It combines a reverse 1031 exchange and an improvement 1031 exchange.

Here are some key points about this type of exchange:

A reverse exchange occurs when the taxpayer wants to acquire the replacement property before closing on the relinquished property.
The exchange facilitator holds or "parks" title to the new property on behalf of the taxpayer.
This combined strategy allows improvements to the acquired replacement property.
Reverse exchanges enable taxpayers to lock up the replacement property before transferring their relinquished property to a buyer.
Documents must be sent to all appropriate parties for the process to be successful.

Reverse Construction Exchange

A reverse construction exchange is a combined strategy that allows an investor to acquire their replacement property first and improve it before selling the relinquished property.

It involves the following steps:

An Exchange Accommodation Titleholder (EAT) holds title to the replacement property on behalf of the exchanger.
The exchanger then finds a buyer for the relinquished property and closes on the sale.
The proceeds from this sale are used to pay off any existing debt and fund improvements on the replacement property.
The EAT transfers the title of the improved replacement property to the exchanger.

Key Takeaways

A 1031 exchange is an excellent tool for real estate investors to defer capital gains tax and free up more capital for investment in the replacement property. It's essential to remember that exchanges must be appropriately structured and adhere to all IRS rules, but when done correctly, they can provide significant tax savings.

For those looking to learn more about 1031 exchanges, Royal Investing Group Mentoring offers resources and guidance on how to take advantage of this powerful tool. Join us and start taking control of your financial future!

Understanding 1031 Exchanges and Asset Protection Entities

Anyone keeping up with real estate market trends or news will inevitably encounter mention of the 1031 exchange. The 1031 has even made its way into investment jargon, as if we need more confusion in that area.

Some people insist on using “1031” as a verb, as in when you overhear that investor at your MeetUp group asking his buddy: "Should I 1031 that property for the condo down the block?"

While we can’t condone the use of this verbiage, we can say the 1031 is useful. But it’s no wonder folks have questions. Today, we’re here to demystify the 1031, its uses, and how it works in the context of your asset protection plan.

What is a 1031 Exchange?

1031 Exchanges, so named for the IRS code portion that permits them, are a type of real estate “swap.” In a 1031 exchange, an investor can sell one investment property and use the proceeds to buy a similar property that is worth as much or more than the one being sold. By doing so, that investor gets temporary relief from capital gains taxes.

Ordinarily, capital gains taxes would be owed upon the sale of one property. But this cost can be a major expense, one that traditionally would come out of your budget for any potential “replacement” property. For this reason, investors opt to take advantage of the 1031 exchange when possible. Without capital gains taxes in the mix, the real estate investor can easily reinvest the full pre-tax value of the first property towards a second.

But of course, it is crucial that investors considering this move are clear about what they want out of it, and whether the terms of their deal meet the IRS’s criteria. Let’s take a closer look at what is required if you want to perform a 1031 exchange transaction.

1031 Exchange Rules

For a proper 1031 exchange to take place, the following three circumstances must be present:

Properties must be similar enough to meet the legal definition of “like-kind.” Determination of this will depend on your intended use of the property, which should fit the next criteria as well. Like kind properties will have the same listed owner. Major asset class changes on their own, like switching out an office space for an apartment complex, aren’t violations of this rule. You can even swap one property for two, provided the next criteria are also met.
Properties must be investments or otherwise business-owned. Your personal home cannot enter the equation at all.
Property purchased must be greater than or equal to the value of the property being exchanged. Value for these purposes means both equity and net market value.

If the deal does not meet these terms, it won’t be possible to reap the full tax benefits of a 1031 deal. There are cases where investors who meet all but the third criterion execute “partial 1031 exchanges” on properties of lesser value, but in doing so, they forfeit the full tax protections of an ordinary 1031 exchange. Finally, keep in mind that these are not all of the requirements but simply the basics. For more information, see our article: Is a 1031 Exchange Investment Strategy Right For Me?

Plan Ahead For Successful 1031 Exchanges With Asset Protection Entities

Using legal tools like the Anonymous Land Trust, LLC, or Series LLC is great for your asset protection plan, but may pose potential issues during a 1031 exchange. We find these situations are best avoided through simple proactivity. The further ahead you can anticipate your desire to do this kind of real estate deal, the better. Let’s take a closer look at some possible problems, and why planning ahead helps.

Entity Issues: LLCs and 1031 Exchanges

The good students of the Royal Legal School of Asset Protection all know what we tell people about keeping property in your own name: just say no. Entities controlled by the investor are far preferable for several reasons. You might need one to begin with for simply conducting business. But they also make suing you personally for any liabilities relating to your investment property a chore for would-be litigants.

The Internal Revenue Code specifies that the property you take in a 1031 exchange must be titled in the same name as the property you give up. For those who purchased property in their own name for financing, then transferred it into an LLC or other structure, the titling requirement can pose issues. But if you, say, sell a property from an LLC but later learn you would need to acquire the second property in your personal name, you would be in violation of this requirement. Your exchange would become void.

Planning ahead is helpful because you can simply transfer the first property into your own name before making the sale. This will be helpful if you need financing again, and most owners of residential real estate will find that there is not an affordable and practical way to make this exchange directly to and from an LLC, even when there isn’t a particularly strong need for financing.

Properties Owned By Multiple People Through Partnerships

Issues with 1031 swaps can also come up when the initial property is owned by multiple people through a Limited Partnership. Again, in this situation, the problem is about titling. However the sold property is titled is also going to need to be the way you buy the next one. Most of the time, the same “cure” can be used as for the first problem: plan in advance regarding titling.

Sometimes, you may want to execute a 1031, but your partner wants to cash out. Investors in this position can execute a move called a “drop and swap.” Essentially, you would be bowing out of the partnership as it is currently structured. With the help of a qualified real estate attorney, you can deed property out of the partnership and into the names of each individual involved. Your legal relationship to your former partners can become one of tenants-in-common, which allows each person to decide whether to reinvest in the exchange or drop out.