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.
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.
For a proper 1031 exchange to take place, the following three circumstances must be present:
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?
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.
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.
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.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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