An investor entering a 1031 exchange has a lot to consider: tax benefits, real estate logistics, finding the right professionals, IRS deadlines, and so on. However, there is one aspect that is often overlooked but can make an impact on your overall financial health, and that is property insurance.
1031 exchanges are primarily used for tax-deferral benefits; however, this transaction has a direct and indirect impact on your property insurance coverage, exposure, and insurability. How does a 1031 exchange impact property insurance exactly? Realized 1031 has shared the answers.
Named after Section 1031 of the Revenue Code, a 1031 exchange is a tax-deferred investment strategy that delays the payment of capital gains taxes. You relinquish a property and acquire a like-kind asset to avoid creating an official sale. Both assets must have been held for investment or business use, and you’ll need to work with a qualified intermediary to ensure an arm’s-length transaction. Finally, the entire transaction must be done within 180 days to maintain your tax-deferred status.
Sales can occur during a 1031 exchange, even though no constructive receipt is made. As such, these sales can impact your property insurance in various ways.
Here are some of the direct and indirect ways the exchange can influence your property insurance.
The period between selling the relinquished property and acquiring the replacement property is a time of vulnerability. Once the sale closes on the original property and you haven’t acquired the replacement asset, you could face a gap in insurance that leads to exposure. You can work with your qualified intermediary for possible solutions, such as temporary general liability coverage if you don’t own property during the interim.
Identifying and preparing the replacement asset for closing won’t automatically lead to coverage. You’ll have to purchase one yourself to regain property protection. The lack of property insurance may lead to issues like closing delays, lenders refusing to approve financing, or uninsured damages that may happen immediately after closing. As such, purchasing property insurance in advance can help you avoid these issues and ensure protection.
The new property may be a different type than the one you sold. For example, you may go from a residential duplex to a mixed-use or industrial facility. This change can significantly affect your insurance requirements. Here are some things to consider that may affect your property insurance needs.
Your insurer may require different underwriting standards or even a specialty policy depending on the asset class.
There are cases when you need additional financing along with the proceeds of the relinquished property sale. However, your lender may require additional types of insurance to approve your financing. Property taxes, a non-negotiable requirement, may need modification to increase coverage up to replacement cost value. In addition, your lender may ask for liability limits that meet their minimums. These requirements vary from sector to sector. As such, it’s important that you do your research ahead of time to prepare for these new 1031 exchange insurance requirements.
In the whirlwind that is the like-kind exchange, it’s easy to overlook matters like property insurance. However, knowing when to purchase one during the transaction, as well as the additional requirements or riders you need, helps protect against uninsured damage and streamlines financing. A savvy investor will not neglect property insurance but instead assigns time and resources to ensure a well-protected investment.
Sources:
https://www.investopedia.com/terms/p/property-insurance.asp