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A 1031 exchange allows investors to swap an investment property for another investment property and defer capital gains tax that they would otherwise have had to pay. The name came from IRS code Section 1031 created in 1954 and has been supported by both political parties since creation.
Example: Investor sells a piece of vacant land and purchases a duplex. IRS code Section 1031 allows any capital gains tax from the sale of the vacant land to be deferred due to the purchase of the duplex.
"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" - IRC Section 1031
There are rules that have to be met in order for the exchange to qualify under the tax code.
Rule 1 - The property that's being relinquished and the new property being purchased must be like-kind but are not required to be in the same class. Like-kind properties are defined as commercial, residential, undeveloped or developed. Rule 2 - Proceeds from the sale of the relinquished property must be held in escrow by a third party known as a Qualified Intermediary (QI). CPA's, Real Estate Agents, Attorney's, or any other agent cannot hold the funds to qualify.
Rule 2 - In order to accomplish a fully tax-deferred exchange the investor must exchange even or up in value and in equity and debt. Tax is computed on the amount of gain on the sale, or the amount of boot received, whichever is lower.
Rule 3 - Must identify interest of like-kind replacement property(s) in writing within 45 days of the sale of the relinquished property. Known as the "45-Day Rule".
Rule 4 - Must close on the like-kind replacement property(s) within 180 days of the sale of the relinquished property. Known as the "180-Day Rule".
What Relinquished Properties Qualify for a 1031 exchange? (IRC Section 1031 uses determination based on intent and predominant use.)
1. What does Intent mean?
Intent means the property does not need to be actively generating revenue. There are many factors an investor can document to prove intent with the exception that the property can not only be held for sale.
2. What does Predominant Use mean?
Predominant use allows an exception to the rule that the property has to be exclusively held for business or investment purposes. The IRS created safe harbor guidelines, that if followed the property would not be challenged by the IRS on business or investment intent. Common examples would include rental properties.
3. What are the safe harbor guidelines that must be followed?
A) The property must be held for at least 2 years.
B) During each of the 2 years the property must be rented out for at least 14 days.
C) The owner of the property cannot personally use the property for more than 14 days or for more than 10% of the days the property was rented out.
This is for informational purposes only, does not constitute individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.
There are material risks associated with investing in private placements, Delaware Statutory Trusts ("DSTs") and real estate securities including the potential loss of the entire investment principal, illiquidity, tenant vacancies impacting income and revenue, general and real estate market conditions, lack of operating history, interest rate risks, competition, including the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and investors should read the PPM carefully before investing paying special attention to the risk section.
DST 1031 properties are only available to accredited investors (typically defined as having a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last two years; or have an active Series 7, Series 82, or Series 65). Individuals holding a Series 66 do not fall under this definition) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney.
The rules and regulations of the QOZ Program are complex, and compliance with the QOZ Program comes with significant challenges such as appreciation unpredictability, certain neighborhoods may be less accommodating to development, illiquidity for up to ten or more years, availability and cost of construction and development financing uncertainty, development and redevelopment real estate risks, as well as a number of Jobs Act interpretation uncertainty which may impact future risks, if any.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
Potential cash flows/returns/appreciation are not guaranteed and could be lower