A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code. It allows an investor to sell their property or business and buy another one without incurring any capital gain.
In other words, a 1031 exchange, when used correctly, can allow an investor to take money that would otherwise be taxed and invest it back into more valuable investments.
In Missouri, and indeed other states, selling an investment property usually attracts some state and federal taxes. A 30 percent tax is usually the norm and that’s where a 1031 exchange comes in. It can help you defer payment of such a tax.
What’s more, there is no limit to how many tax deferments you can make. This means that you can make as many as you may want, effectively enabling you to accumulate considerable wealth.
Below is a basic guide to the 1031 exchange in the state of Missouri.
Does an Exchange Really Occur?
A 1031 exchange is exactly that, it’s an exchange. To take advantage, you’ll need to swap one property out for another. Of course, there are certain requirements that the properties being exchanged must meet. Specifically, they must be “like-kind.”
According to Section 1031 of the Internal Revenue Service Tax Code, “like-kind” means the two properties share the same nature and character. It also goes without saying that the two properties must be U.S.-based.
What Properties Qualify for a 1031 Exchange?
The following are examples of properties that could qualify for an exchange:
- Mitigation credits for restoring wetlands for other mitigation credits.
- Rental ski condo for a three-unit apartment building.
- Residential, commercial, industrial, or retail rental properties for any other real estate.
- Fee simple interest in real estate for a 30-year leasehold or a Tenant-in-Common interest in real estate.
- Raw land or farmland for improved real estate.
What Types of Properties Don’t Qualify for a 1031 Exchange?
“Like-kind” properties don’t include the following:
- Trust certificates
- Partnership interests
- Securities, debt
- Stocks, bonds, other types of notes
- Inventory, stock in trade
- Foreign real estate
The Rules for a 1031 Exchange
Besides the two properties being “like-kind”, there are other rules that an investor must follow in a 1031 exchange. The rules are as follows:
The Exchange Must be Done Before the Sale Occurs
Following this rule is key, lest the entire process be deemed null and void. Prior to the sale of the property being exchanged, an exchange must be set up by an exchange accommodator or facilitator.
Setting up the exchange is normally a straightforward process. Once the setup is done, the Qualified Facilitator must notify the escrow company to make the fund’s transfer to avoid the exchanger from having a “constructive receipt.”
The Values of the Properties Being Exchanged Must be of Similar or Greater Value
The replacement property’s aggregate value must be greater than or equal to the relinquished property’s aggregate value, minus the costs associated with the sale of the property.
Common costs associated with the sale of a property include attorney fees, title, brokerage fees, and escrow. If, for example, a property has been sold for $500,000 with $25,000 sale costs, then the replacement property must have a value of at least $475,000.
The Owner of the Property Must Pay Capital Gains Tax on “Boot”
The term “boot” refers to a non-like-kind property that’s received in an exchange. “Boot” is typically in the form of personal property, debt relief, an installment note, or cash. It’s valued to be the “fair market value” of the non-like-kind property received.
In a 1031 exchange, “boot” is considered to be an “economic benefit.” The Internal Revenue Service (IRS) supports 1031 exchanges because they create an incentive for taxpayers to maintain continuous real estate investments.
Acquiring less replacement property or taking cash proceeds is considered “boot” and it is taxable. It should be noted that the tax rate applied on a “boot” will be the steepest Federal tax rate.
A Taxpayer Who Sells or Acquires the Exchange Property Must be the Same
The person named on the title during the time of closing must be the same person who performs the exchange and therefore must be on the replacement property’s title immediately after doing the acquisition.
The Property Owner has 45 Days to Identify the Replacement Property
The replacement property must either be identified or closed within 45 days from the date of transfer of the property being exchanged.
Three methods are available when it comes to the identification of replacement property. That said, an exchanger can only select and use one for the following exchange method, the 95% rule, the 200% rule or the 3 property rule.
After the 45 days are over, no new changes or replacements may be included or acquired.
An Owner has 180 Days to Complete the Exchange
Once the replacement property is identified, the exchanger will have another 135 days to finalize the acquisition.
Are there different types of 1031 Exchanges?
Yes, you can conduct a 1031 exchange using either of 3 ways:
- Delayed 1031 exchange
- Reverse 1031 exchange
- Build-to-Suit 1031 Exchange
There is no doubt that a 1031 exchange can be a great way for an investor to defer payment of capital gains tax after the sale of an investment property. Best of all, there is no limit to how many times you can do so.