1031- What you need to know
We have asked guest blogger Stacey J. Morimoto, Founder & CEO of Investment Capital Resources to weigh in on this hot topic.
The fourth quarter of 2017 was a stressful time for many real estate investors. As lawmakers tossed around the idea of eliminating section 1031 from the tax code, many investment property owners around the country sat at the edge of their seats waiting for the outcome of the much-anticipated tax legislation.
On Friday, December 22, 2017, President Donald Trump signed the massive tax bill and in it was a significant change to code section 1031. As of January 2018, tax payers would no longer be able to exchange personal property on a tax deferred basis. The rest of section 1031 remained unscathed. A huge relief to real property owners who have used this powerful tool to preserve and grow their wealth for centuries.
Today as investors face peak market conditions, incremental interest rate hikes and the high season of real property transactions upon them, investors will be turning once again to the coveted 1031 tax deferred exchange to protect their real estate fortunes from value and earning erosion due to taxation.
This article will cover some of the positive and negative aspects associated with tax deferred exchanges. We will also cover some of the important things to consider when purchasing replacement property in a tax deferred exchange and finally explore a little know passive investment option for those who would like to relieve themselves from the obligations associated with property ownership.
Let’s start with why investors use 1031 to being with. The primary benefit and main reason why investors use section 1031 of the tax code is to defer the payment of Federal capital gains, State income and depreciation recapture taxes. These three taxes combined can easily add up to well over 30% of the net proceeds associate with an investment property sale. Clearly, the long term earning power of a properties full equity cannot be overstated. Losing 30% or more of the proceeds from a sale simply isn’t palatable for most investors.
For those investors who have owned an asset that is completely depreciated, establishing a new basis and picking up depreciation expense deductions is another significant reason to utilizing the tax deferred exchange. Finally, many investors are looking to grow their property portfolios and exchanging a single asset for multiple properties is a great way to accomplish this goal.
Now that we have covered some of the core benefits associated with a tax deferred exchange, let’s take a closer look at some of the challenging aspects of the 1031 exchange. First and foremost, during the planning stage of every exchange, investors must come to grips with the fact that finding a suitable replacement property can be extremely difficult. In a low inventory environment such as the one we find ourselves in today, this risk associated with an exchange becomes exacerbated. Spend plenty of time planning and determining exact locations and property types you’d like to invest in prior to selling what you currently own.
The IRS doesn’t make an exchange easy on investors. There are very strict time requirements placed upon exchanges. Once a property sells, the taxpayer must identify the property or properties it will attempt to purchase within 45 days of closing on the sale property. The taxpayer must then close on the purchase or purchases it identifies within 180 days of the close of escrow on the sale. Additionally, the investor must purchase property comprised of an equal or greater amount of equity and debt as compared to the sale property. As you may be starting to conclude, this transaction can become quite complex and aligning yourself with experienced professionals to help guide you through the process is paramount to the success of any exchange.
There is a strategy out there that can work to solve many of the dilemmas that property owners face when attempting a tax deferred exchange. Over the past couple of decades, an industry has emerged where full service real estate investment companies have developed and have been refining passive ownership structures which simplify the 1031 exchange process. For those investors who are looking for a way to reduce the management burden associated with their investment properties while maintaining the potential benefits they have grown accustomed to, the Delaware Statutory Trust or DST may be a viable solution.
The DST offers several potential benefits which include management free ownership of institutional quality properties that are structured to comply with IRS guidelines. The DST also provides the potential for monthly income distributions and future appreciation potential. Finally, because DST’s are disregarded entities for tax purposes, investors are entitled to the expense deductions derived from the property held in trust including the all-important depreciation deduction.
Like with any investment, DST’s expose investors to certain risks. First, DST’s are investments in real property and all risks related to owning investment real estate apply, including the lack of liquidity,
complex structures and the risks of leverage. Second, cash flow may fluctuate or even cease, and property values are likely to fluctuate over time as markets shift and change. These can be either positive or negative fluctuations depending on the market where the DST property is located. Finally, there are tax risks, financing related risks and other risks that should be considered prior to investing in a DST.
In summary, as we approach the high season of real estate sales activity, the 1031 exchange can be a wealth preservation instrument that every investor should know about. Utilizing the benefits of the 1031 tax deferred exchange are paramount to maximizing returns and being prepared to deal with the challenges one may face when exchanging should help to minimize the downside risks. Plan early and know all your options!!
The author of this article is a 1031 and DST specialist who has been assisting Southern California real estate investors with their tax deferred exchanges for the better part of two decades. For answers to your 1031 questions or more information on DST’s, visit www.ICRAdvisor.com or call 844-427-1031.
The contents of this invitation constitute neither an offer to sell nor a solicitation of an offer to buy any security, as such an offer can be made only by prospectus. Investing in real estate securities may not be suitable for all investors and may involve significant risks. These risks include, but are not limited to, loss of principal, lack of liquidity, adverse changes in real estate markets and conflicts of interest. Investors should also understand all fees associated with a particular investment and how those fees could affect the overall performance of an investment. Past performance of investments is no indication of future results.
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