Is a 1031 Exchange Right for You?

Business owners and taxpayers who want to accomplish a wide range of business and/or investment objectives have several tax benefits that they may be eligible to take advantage of. One of those options is a 1031 Exchange. Through a 1031 exchange, real estate owners can defer capital gain taxes when they sell a business or investment property and use the proceeds of the sale to purchase another property ‘similar’ to the first. So, how does a 1031 exchange work and how could it benefit you? Take a look.

What is a 1031 Exchange?
A properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC Section 1031 (a)(1) states:
“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 real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
To understand the powerful protection a 1031 exchange offers, consider the following example:
  • Assume an investor has $400,000 in gain and also $400,000 in net proceeds after closing. Assuming an investor with a $400,000 capital gain and incurs a tax liability of approximately $140,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $260,000 in net equity remains to reinvest in another property.
  • Assuming a 25% down payment and taking on new financing for the purchase with a 75% loan-to-value ratio, the investor would only be able to purchase a $1,040,000 replacement property.
  • If the same investor chose to exchange, however, he or she would be able to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property, assuming the same down payment and loan-to-value ratios.
  • As the above example demonstrates, tax-deferred exchanges allow investors to defer capital gain taxes as well as facilitate significant portfolio growth and increased return on investment. 
What is a Like-Kind Property?
An accurate understanding of the key term 'like-kind' – often mistakenly thought to mean the same exact types of property – can reveal possibilities that might have been dismissed or overlooked. So, what does 'like-kind' really mean when it comes to a 1031 exchange? 

IRC Section 1031 limits like-kind property to only certain types of real property. The term like-kind property refers to the nature or character of the property, rather than its grade or quality. Real property must be exchanged for like-kind real property. Furthermore, real property held for investment can be exchanged for real property used in a trade or business or real property held for use in a trade or business can be exchanged for real property held for investment. The types of real property which can be exchanged under Section 1031 are very broad. Examples of like-kind real property include:
  • Unimproved property for improved property
  • Fee for a leasehold with 30 or more years
  • Vacant land for a commercial building
  • Duplex for a retail property
  • Single-family rental for a multi-family apartment
  • Conservation easement for warehouse to be used in the taxpayer’s business
  • Industrial property for rental vacation property in a resort area
Is a 1031 Exchange Right for You? 
When considering a 1031 exchange, it's important to begin working with an experienced title company at the Lake of the Ozarks early in the process to understand how title to the different properties will need to be insured and how you can obtain the best combination of coverage and cost. An important part of title insurance at the Lake of the Ozarks is its emphasis on risk elimination before insuring. This gives you, as policyholder, the best possible chance for avoiding title claim and financial loss. It is our goal to minimize your risk and maximize your investment.

At Arrowhead Title, we partner with Asset Preservation Inc. to ensure our clients get the best possible service in these types of real estate transactions. This ensures that all requirements are met to secure your best interest. Contact Arrowhead Title to discuss whether a 1031 exchange is the right solution for your next real estate transaction.

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