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What is a 1031 Exchange?

A 1031 exchange is a transaction in which a taxpayer is allowed to sell one property and buy another without a tax consequence. This can be done through a simultaneous or delayed 1031 exchange. The transaction is authorized by Section 1031 of the IRS Code. It is the best strategy for the deferral of capital gains tax that would ordinarily arise from the sale of real estate investments. 

A successful like-kind exchange results in the taxpayer being able to utilize 100% of the proceeds from the sale of property to purchase a new property, thereby deferring capital gains taxes. 

Real estate owners can accomplish virtually any objective with a 1031 like-kind exchange, including greater leverage, diversification, improved cash flow, geographic relocation, and/or property consolidation. 

How does it work? 

A 1031 exchange is usually a three-way delayed exchange, referred to as a "Starker Exchange", in which an intermediary is used to facilitate the transaction. There are four basic steps: 

  • Seller arranges for sale of property and includes exchange language in contract. 
  • At closing, sales proceeds go to a Qualified Intermediary for a 1031 Exchange. 
  • Seller identifies potential exchange properties within 45 days of the closing.
  • Seller completes 1031 exchange within 180 days of closing. 

In a section 1031 transaction, these steps can also occur simultaneously. Preferably, before you sell your property, you need to consider what type of replacement property will work best for you, and whether or not you want to own a whole or partial interest in a property. Increasingly, investors are choosing to purchase a partial Tenant-in-common interest for several reasons. 

Advantages of Undivided Tenant-in-Common Interest Ownership It is often difficult to locate a property that has the right purchase price, debt ratio, and closing schedule to meet the requirements for 1031 tax-deferred exchanges in the short 45-day time frame AND arrange any financing that may be necessary. A Tenant-in-common ownership interest has a number of advantages, such as: 

  • Flexible size to match your needs 
  • Pre-arranged financing 
  • No management hassles 
  • Potential for increased after-tax cash flow 
  • Economies of sale 
  • Can be identified and closed in a timely manner 
  • Investment can often be diversified into more than one property 

How will a tenant-in-common 1031 exchange benefit me? 

Through tenant-in-common programs, you may own management-intensive real estate. Although you are comfortable with real estate investments and have had good returns in the past, you do not like the daily headaches that can accompany real estate management. 

You are ready to give up the hassles of dea ling with tenants, maintaining facilities, paying property taxes, etc. You would like to sell your property but are faced with onerous tax consequences on the sale. You'd rather enjoy the income from the property and let someone else manage it. 

With a TIC 1031 Exchange, you can do exactly that. 

A TIC 1031 exchange allows you to exchange your management-intensive property for an institutional-quality property with the potential to generate steady income, tax benefits and appreciation. With a TIC 1031 exchange properties, you no longer have to feel burdened by your real estate. Through your management contract, a manager will be retained to manage the asset while you enjoy all the benefits of income property ownership and freedom from management duties. 

Your income from the replacement property may be higher than what you were receiving from the original property. You can earn substantial cash flow that may be up to 60% sheltered by the depreciation of your new basis in your TIC purchase. 

No capital gains taxes may be due until the replacement property is eventually sold. If you pass away while owning a property, your heirs will receive a stepped up basis and the capital gains tax will be completely avoided. 

How do I get started? 

Discuss your specific needs with your registered representative who will be happy to answer your questions and provide you with the information you need to consider a 1031 exchange or a reverse 1031 exchange. If needed, contact K2 Commercial Finance for the names of registered representatives you can trust. We are not registered representatives but are always happy to help when we can.

1031 Do's & Don'ts 

DO advanced planning for the exchange. Talk to your accountant, attorney, broker, financial planner, lender and Qualified Intermediary. 

DO NOT miss your identification and exchange deadlines. Failure to identify within the 45-day identification period, or failure to acquire replacement property within the 180-day exchange period will disqualify the entire exchange. Reputable Intermediaries will not act on back-dated or late identifications. 

DO keep in mind these three basic rules to qualify for complete tax deferral: 

  • Receive only "like-kind" replacement property. 
  • Use all proceeds from the relinquished property for purchasing the replacement property. 
  • Make sure the debt on the replacement property is equal to or greater than the debt on the relinquished property.(Exception: a reduction in debt can be offset with additional cash; however a reduction in equity cannot be offset by increasing cash.) 

DO NOT try to do a 1031 exchange yourself using your CPA or attorney to hold title or funds. IRS regulation requires a Qualified Intermediary to properly complete an exchange. Call us for the name of one that operates in your area. 

DO attempt to sell before you purchase. Occasionally exchanges find the ideal replacement property before a buyer is found for the relinquished property. If this situation occurs, a "reverse" exchange (buying before selling) may be necessary. Exchangers should be aware that reverse exchanges are considered a more aggressive exchange variation because no clear IRS guidelines exist. 

DO NOT dissolve partnerships or change the manner of holding title during the exchange. A change in the Exchanger's legal relationship with the property may jeopardize the exchange.

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