Let’s say you’re an investor with tangible real estate holdings. Perhaps you want to upgrade those holdings by acquiring higher-value (or higher cash-flow) real estate property. Or you might be tired of hands-on ownership and are considering exchanging that income-producing property into a Delaware Statutory Trust (DST).
Whatever your goal in either situation, a 1031 exchange can provide a way to get you into that next property, while potentially deferring capital gains and depreciation recapture taxes. But before diving into the first replacement property that crosses your line of sight, be sure to consider the following.
One key to a successful 1031 exchange (i.e., one that allows you to defer taxes) is that the replacement property or properties you target are of equal or greater value than your relinquished property. You can use the Three-Property-Rule, 200% Rule, or 95% Rule when determining the fair market value (FMV) of those replacement property/properties.
As an aside, if the replacement property or properties carries a FMV less than that of your relinquished property, you can still get the exchange done (as long as you follow the deadlines). This is called a partial exchange. You’ll likely have to pay capital gains and depreciation recapture taxes on the amount remaining after acquiring the replacement property. This is called boot.
Here’s what you can consider for replacement properties:
Here’s what is NOT eligible for a 1031 exchange property:
To ensure that you benefit from potential tax deferral through a 1031 exchange, you must adhere to the IRS-mandated deadlines:
Specifically, you want to be sure that you’ll be able to close on those replacement properties within that 180-day timeframe. If there’s any delay from the sellers of those properties, it could potentially cost you a tax deferral.
“Replacement property” doesn’t automatically mean “perfect property.” Whether you’re buying the targeted property up front or are using it as a 1031 exchange replacement property, thorough due diligence is essential.
You need to understand everything you can about that property, including potential cash flow, market demographics and fundamentals, and even municipal, county, and state laws that might impact the property’s operations.
Another thing to do while browsing potential 1031 exchange listings is to ensure that your team is set up to handle the process. This should include a Qualified Intermediary, an experienced broker or agent, and a seasoned tax advisor and/or tax attorney. These individuals can help steer you in the right direction and ensure that the like-kind exchange is completed successfully.