1031 exchange is not a mere tax bypass strategy. It’s a useful wealth creation principle. This exchange is popularly used by real estate investment moguls to grow their portfolios and increase net worth faster and efficiently.
By using 1031 exchanges, real investors can sell a real estate property and reinvest the proceeds into another real estate asset and sidestep any capital gains tax associated with the transaction. Let’s say, you are considering selling an investment or business asset and purchase another of its kind (like-kind property).
IRS allows you to structure the two transactions as a 1031 exchange to bypass capital gains tax and depreciation recapture tax. This means that you can invest 100 percent of your old property’s value into the new investment.
What Is a 1031 Exchange?
1031 exchanges are named for the IRS Section 1031 of the IRS’s tax code. The provisions of this section enable you to eliminate or reduce taxes on the sale of a real estate investment or business. If correctly used, they offer significant tax benefits for businesses or individuals selling or buying commercial real estate properties.
Until 22 December 2017, the 1031 exchange applied to personal property sales as well. However, the 2017 Tax Cuts and Jobs Act reviewed this, and now only real estate property assets qualify for 1031 exchanges.
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Whereas the tax deferment provided by a 1031 exchange is an excellent opportunity for investors, the IRS Section 1031 has some complex points that may prove problematic if you do not understand all its working parts.
As a general rule of the thumb, consider seeking professional assistance from a qualified intermediary at every step of the process to avoid common pitfalls.
In this interest, we have made you a complete overview of a 1031 exchange, how it works, and essential steps (and everything in between) to keep you ahead of the curve. Have a look.
The Main Types of 1031 Strategies
There are five different types of 1031 exchanges, each fitting different situations. These include:
- Simultaneous exchange- This type of exchange is one in which you purchase or close on a replacement property on the same day you relinquish or sell the old property
- Delayed exchange- Here, you first sell your property and then find a replacement property post-sale but you must find the replacement property within a certain period of time (usually 45 days)
- Reverse Exchange- This is where you first buy the replacement property and then sell the initial property with the help of a qualified intermediary. This exchange is the way to go, especially when you want to acquire a replacement property when it’s a sellers’ market, and there are competing offers or a pressing need to close quickly.
- An Improvement Exchange- Also known as a built-to-suit exchange or construction exchange, is an option where the new property costs less than the old property. The extra funds are used towards renovating the replacement property. The IRS tax code also requires that you complete the improvements within 180 days of relinquishing the old property.
How a 1031 Exchange Works
In a typical real estate transaction, you can expect to incur combined taxes (state capital gain tax, federal capital gain tax, net investment income tax) of up to 40 percent of the capital gain when you sell an investment or property. However, the 1031 exchange allows you to defer capital gain taxes, enhance returns and facilitate portfolio growth on your investments.
In any 1031 exchange process it is important to consider working with a qualified intermediary, It helps you in the following ways:
- Gives you a comprehensive understanding of the exchange process
- Helps you comply with laws and avoid negative tax implications
- Guarantees you full access to the potential benefits of a 1031 exchange
For instance, if you accurately interpret the key term like-kind (usually thought to mean the same exact type of assets), you can identify great exchange possibilities that you might have otherwise overlooked.
Here are important steps and highlights about how a 1031 exchange works.
Step One: Identify the Investments or Assets You Want to Sell
In a 1031 exchange, the first step is to identify the property you want to sell. This exchange typically applies to investment or business properties such as real estate and hotels. Your personal property, including a vacation home or a primary residence, may not qualify for a 1031 exchange.
Step Two: Choose the Property You Want to Purchase
The business property or investment you are selling and the replacement property have to be like-kind, which means they are of the same character, class, or nature but not necessarily the same grade or quality. You can exchange your hotel investment with another hotel or hotel real estate property.
Also, note that property outside the U.S is not considered like-kind to property inside the U.S.
Step Three: Identify a Qualified Intermediary
The idea behind a 1031 exchange is that you are exempted from income tax/capital gain tax when you don’t receive any proceeds from the sale of your property. A good way to ensure that you don’t receive these proceeds (and incur hefty tax liabilities) is by working with a qualified intermediary, also known as an exchange facilitator.
Usually, a qualified intermediary holds the proceeds in escrow until the exchange is complete. Strive to exercise caution and perform due diligence when choosing a qualified intermediary. If your exchange facilitator flakes on you or goes bankrupt, you may lose money. An unreliable QI may also make you miss important deadlines and cause you to have complex tax implications.
Do you need a reliable qualified intermediary you can trust? JTAC (global experts in financial administration) has partnered with NewGen Advisory (America’s premier hospitality brokerage firm) to offer you a trusted partner you can count on throughout the exchange process and beyond.
Step Four: Determine How Much of the Proceeds You Will Invest Towards the New Property
IRS’s section 1031 does not really require you to reinvest all of the sale proceeds in a new investment. However, you will incur capital gains tax on the sale proceeds that you don’t reinvest in the like-kind property. You can only defer taxes on the portion you reinvest.
Step Five: Check on the Calendar
In the exchange process, you have to fulfill two deadlines, or the gain on the sale of your property will become taxable. In the first instance, you have 45 days after selling your property for you to identify potential replacement assets. This has to be done in writing and then notify the seller and your qualified intermediary.
Secondly, you will need to purchase the replacement property within 180 days of selling your old property.
Step Six: Inform the IRS About Your Transaction
You will also need to file the IRS Form 8824 in your tax returns. This form requires you to explain who was involved, describe the properties, provide a timeline and detail the money involved.
Benefits of a 1031 Exchange to Hoteliers
1. Tax Benefits
One of the main reasons you should consider a 1031 exchange is the tax benefits that come along with it. A 1031 exchange transaction allows you to sell a business property and defer paying the capital gains tax by buying a replacement property or properties.
This helps you reinvest the proceeds and keep the money working for you instead of paying out up to a third of that equity to Uncle Sam (the taxman/IRS). However, you will need to work with a qualified intermediary who will receive the funds in between the transactions.
2. Increase Your Cash Flow
When you transact using a 1031 exchange, you can significantly boost your cash flow and increase your income. For instance, you can sell a lower value, high maintenance, or underperforming property and invest in one that will make you more money, depending on your investment goals. Keep the money saved from the exchange and recommit it to your investment portfolio.
3. Diversify or Consolidate Your Hotel Investments
The strategy for obtaining, growing, or evolving a real estate portfolio is often unique to each person. However, the 1031 exchange is a great way for hotel investors to diversify or consolidate real estate investments and achieve their investment goals faster.
You can sell one of your hotel investment properties and then purchase a different or even multiple properties to diversify. This will help you spread out the risks of your investments and expand your business to new markets.
You can also use a 1031 exchange to consolidate your hotel investments portfolio as your investment goals change with time. Consider selling your properties that no longer fit your goals and purchase others that do.
4. Streamline Your Hotel Investments
Multiple properties with a lot of management and maintenance needs can make it difficult for you to focus on other projects that are important to you. A 1031 exchange allows you a hassle-free opportunity to get rid of time-consuming properties and buy hotel investments with a projected growth potential.
Why NewGen Advisory:
- America’s Leading Hospitality Brokerage Firm
NewGen Advisory LLC is a full service commercial brokerage solutions company specializing in hospitality and lodging properties. We leverage state of the art marketing strategies to penetrate pools of qualified investors and owners.
- Industry Experts
Numerous complex transactions coupled with years of experience have provided us with a rare sixth sense for locating value and smart hotel investments. Our brokerage experience spans three decades, and we have represented over $1.5 billion worth of transactions in hotel sales. We are hoteliers ourselves; thus, we understand your needs and approach each transaction as our own.
- Customer Centered
All our transactions are based on the best interests of our clients—speed to close and maximum returns on investment. Our people-first approach and extensive network have resulted in sustainable partnerships and rendered us your go-to hotel brokerage company.
Our mantra is simple and on point; to help you make the most proceeds from the sale of your hotel properties. For more information on the 1031 exchange or inquiries on how we can help, feel free to Contact Us today and Let’s 1031.