Refinancing With a 1031 Tax Exchange

One of the key concepts in the 1031 exchange process is that an investor must not draw any cash benefit from the funds resulting from the sale of his or her relinquished property; any kind of monetary benefit from the sale is considered to be boot, and this means, in fact, liable for capital gains taxes. In keeping with this logic, refinancing for the purpose of removing stored value from the 1031 replacement property delves into a rather gray area with regard to acceptability under Section 1031.

In a case involving an investor named Garcia, the court clearly asserted that any benefit gained by an investor resultant from the refinancing of a property in anticipation of selling it in a 1031 tax exchange will be considered to be boot. This court decision set a precedent for dealing with these kinds of situations . Currently, a more popular tactic is waiting until the replacement property has been closed on, and to refinance the piece of property at some point later. This tactic, however, raises some questions about how long it is appropriate to wait before performing this refinancing and removing equity from a property.

The old guard among real estate investors will advise you that you should wait a considerable period of time post-closing (perhaps two years), to make absolutely sure that you’re complying with the intent of 1031 tax exchanges. The popular mindset amongst more liberal minded contingency of real estate investors, however, is to assume that the closing on a replacement property marks the definitive ending point of to the exchange process, and that one need not fret over the substantiation of the exchange from there onward. For a property investor who looks at the exchange process from this perspective, it is not relevant how long one waits before refinancing one’s 1031 replacement property, and many do indeed elect to do this immediately after the closing has occurred.

If you are looking for any kind of hard and fast maxim as to when it is safe to refinance a 1031 replacement property, then you are destined to be disappointed, at least within the confines of this short article. The two schools of thought described in this article are just the opinions of a few, and they are examples of only a few of the viewpoints an investor may adopt. Property investors vary greatly when it comes to the way in which they elect to look at these sorts of gray areas, and the wisest suggestion I can {give you is simply to enlist the help of a qualified tax adviser or other legal expert in making your ultimate decision, and to work together with him or her so that you can decide on the approach that will work best in the context of your particular situation.

A profitable option is to conduct a 1031 tax exchange…

As a player in the real estate game, you must be aware that dollar that you have working for you is compounding your wealth, and, conversely, that every dollar not working for you can be considered a missed chance to further compound your profits. So, when it comes time to put your property up for sale pay capital gains taxes . Every time you pay money to the U.S. government you are throwing away potential profits.

The second and more profitable option is to conduct a 1031 tax exchange. A great way to keep more of your investment funds making you more money is to perform a 1031 tax exchange rather than making an outright sale. A 1031 exchange has a non-recognition provision; this means that you aren’t obligated to pay the taxes immediately following your sale; as a matter of fact, your capital gains liability are deferred for an indeterminate time span, while your funds are compounded by the extra income produced by investing your tax deferment.

To demonstrate, let’s say that you own some small investment properties, like triplexes or duplexes, whose values have increased over time. At this point, your first inclination may be to sell these properties and collect on your investments. But a wise investor with an eye to the future might decide to conduct an exchange and place the money gained from these investment properties towards the purchase of another piece of property, which will, itself proceed to appreciate in value over time and continue to compound your wealth. Best of all, the money available to you as a result of deferring capital gains taxes will function to heighten your ability to leverage for greater loans, maximizing your potential profits.

1031 exchanges are not limited to just buildings and land, either. It is possible to conduct a 1031 exchange on any real estate held for investment in a business or trade, as well as certain types of personal property, from cranes or backhoes to an aircraft or collector car. 1031 exchanges are especially advantageous for those who have money in antiques or collectibles such as collector cars, in light greater capital gains liability on the sale of these types of items. You cannot, however, exchange things like stock, bonds, or interest in an REIT.

So, next time you are in the position to sell a piece of real estate or other investment, pause for a moment and consider the profit you could reap were you to conduct an exchange instead. If you decide to conduct a 1031 exchange instead of selling outright, you can maximize your wealth and come out ahead.

Section 1031 of US tax code

The 1031 tax exchange is a method often used by property investors so that they may indefinitely defer capital gains tax liability on the sale of a property. This is achieved by transferring rights to a property one would like to sell to a qualified intermediary, who holds on to the funds gained from the sale of the relinquished property and uses them to acquire a replacement that complies with the rules set out in Section 1031 of US tax code.

While the present popularity of the 1031 tax exchange may lead one to believe that it only recently came on the scene, this is untrue. Actually, the history of the 1031 exchange extends as far back as 1921, although it was originally was significantly different from the exchange investors know and love. Section 1031 truly came into its own in the ’70s, which saw a host of significant modifications in the way that these exchanges were conducted. These modifications resulted in a more powerful conception of the 1031 process and also created greater interest among real estate investors.

The capital gains tax deferral a 1031 exchange provides to the taxpayer might, at first glance, seem to be a sort of gift from the United States government, however it is, in reality, more like an interest free loan. This is because there is an expectation that the taxpayer will repay the money gained from the tax deferral by paying capital gains taxes on the eventual sale of a replacement property. In addition, this interest free loan is one that may be kept by the investor for an indefinite period of time; an investor may conduct any number of exchanges before ultimately electing to make an outright sale, on which capital gains taxes must be paid.

Section 1031 of US tax code represents a mutually advantageous agreement between the investor and the U.S. government, providing a benefit for the U.S. economy as a whole in addition to the individual taxpayer. In viewing the transfer of value in an exchange as a continuation of an existing investment rather than as a separate transaction liable for taxation, investors gain the opportunity to transfer their money into the best possible investments. This, in turn, boosts the country’s economy by encouraging the growth of new jobs.

As with anything, Section 1031 has detractors. Some advocates of change in Section 1031 will pose the argument that the tax free profit provided to the investor in the exchange process creates an unreasonable advantage. Another common concern is that the strict time limits imposed on some aspects of the exchange process may engender a frenetic rate of buying, with a resultant increase in asking prices for replacement properties. These complaints, however, are only tenuously linked to reality, and the odds that Section 1031 will see any significant changes in the foreseeable future are quite slim. When looking at the big picture, most will concede that the 1031 exchange is immensely advantageous to all parties involved, allowing taxpayers increased profits on the sale of their property while also promoting the creation of jobs and consequently promoting the greater good of the U.S. as a whole. Little doubt exists that the 1031 tax exchange is destined to remain a part of the investment world for decades to come.

1031 To Your Dream Property

An essential fact in regard to 1031 exchanges is that you may not make use of the proceeds of the original sale to construct property you own. This is a frequent pitfall of unwary real estate investors. In order to qualify for a capital gains tax deferral, your replacement property has to be of LIKE KIND with the property it is replacing. Thusly, the property you acquire as a result of the 1031 exchange has to constitute real estate with a value greater than or equal to that of the property sold. An improvement that is incomplete is considered a contract for a service, which constitutes personal property but not real estate. Due to the fact that a property acquired in a 1031 exchange has to be of like kind and equivalent value with the property sold upon closing, it can be hard to find a property that complies with these legal requirements but also fulfills his or her specifications.

So, is there a way to what you really want out of a exchange? There are two main methods by which you can acquire a build-to-suit property that fits your wants and needs as well as fulfilling the accounting requirements necessary for a like-kind exchange.

The first option is to conduct what is known as a poor man’s build to suit in which you, as the purchaser, request that the seller make certain renovations on a piece of property to increase its value prior to closing on the sale. For example, if you were to sell a a piece of property with a value of $100,000, and you were considering a replacement property worth at $10,000, the seller of the property could construct ninety thousand dollars’ worth of improvements to raise the value of the real estate. The finished renovations would constitute real estate, and you would then be able to the property for one hundred thousand dollars, fulfilling the requirement that the two properties be of equivalent value. the majority of sellers, however, will not be very enthusiastic to perform these improvements so that you can make a 1031 exchange.

In the 2nd, more likely scenario a qualified intermediary who is holding your funds can buy the replacement property from the seller and take title to it in a limited liability company, intermediary-owned company. The intermediary would then use the remaining proceeds to construct the necessary renovations on the piece of property. Upon completion, the intermediary returns the property to you, which then permits you to complete the exchange .

Returning to the previously mentioned $10,000 replacement property: the intermediary who was holding your funds would buy the aforementioned piece of real estate at the asking price and would make the necessary renovations with the remainder of the funds, returning the replacement property to you when the value of the property is high enough to establish likeness with the relinquished property.

Although a Build-to-Suit exchange can help you acquire the replacement property that is right for you, it is key to consider the amount of time required for the improvements that you would like to construct on your property. You have only 180 days in which to bring your 1031 exchange to completion, so it is important to be conscious of what work can actually be finished in this time span. Be mindful that a renovation represents real estate when it is completed, and so work in the process of construction doesn’t add to the property’s value. Though you may not be able to modify your property as extensively as you might want, one hundred and eighty days is plenty of time to complete considerable improvements, and to bring your replacement property that much closer to the property of your dreams.

The 200% Rule Should Be Noted As An Applicable Rule Of Identification…

It is recommended that you get a replacement property selected and a purchase agreement prepared before initiating the 1031 process. This is because “The three-property rule” (according 1031 tax exchange regulations) declares that an exchanger of a relinquished or replacement property can identify up to three properties, regardless of their value.

However, the replacement property must be received and closed on within forty-five days to avoid having to pay their capital gains taxes. If the replacement property isn’t received and closed on within the 45-day period, the investor must clearly and unambiguously, on paper, claim and identify the replacement property that is intended to be acquired.

On the other hand, if the property is closed on and received prior to the forty-five day period, the property is considered “identified”, just by receiving of property. If however the buyer intends to exceed the three property limit, the 200% Rule should be noted as an applicable Rule of identification.

Under the Two-Hundred-Percent Rule, the exchanger may identify more than 3 replacement properties, as long as their combined fair market value is not more than two hundred percent of value of the relinquished property.

What’s more, is that the purchaser may be, uncertain of the number of properties that are inclusive in the purchase often times because, a single property can be comprised of more than one plot of land. To identify whether or not the properties are considered a single unit, the presumption should be weighed by the suggestion that these properties are on the same land, listed under the same deed, are being sold by the same owner and are being financed by the same lender.

If these consequences are found to be true, then the multi-parceled property is deemed a single-unit of property. However, if, the property isn’t on the same land or under the same deed, the replacement property will be considered as separate properties.

Simply put, there must be a common, collective use among the properties in order for the properties to be considered a single unit. If someone is unsure if the replacement properties are considered a single unit, they should consult a qualified intermediary to insure compliance with either the 3 Property Rule or the Two-Hundred-Percent Rule.