An investment in real estate or other real property can provide unique investment portfolio benefits. Property owners often seek a steady stream of income, capital appreciation and property-related tax advantages. Yet some property owners may no longer be interested in actively owning and managing property, but still want an allocation in real estate. For those individuals, securitized fractional real property investing may be the perfect fit.
What is a 1031 Exchange?
Internal Revenue Code Section 1031, or as it is more commonly known, the 1031 Exchange, allows the exchanger to defer all immediate taxable liability indefinitely, as they sell one investment property for another within a defined period of time and by meeting certain federally regulated guidelines.
What are the advantages of a 1031 Exchange?
By deferring the tax, you are in effect, receiving an interest-free loan from the federal government, in the amount you would have paid in taxes. Gains from depreciation recapture are postponed. You can proactively cut your tax burden by reallocating your investment portfolio, acquiring and disposing of properties without paying taxes on any gains. As the value of your investment properties increase, you can repeatedly trade up, enriching your portfolio, all while repeatedly deferring taxes. Upon the death of the property owner deferred tax on capital gains is forgiven and heirs receive a stepped-up basis equivalent to fair market value.
What are the characteristics of a 1031 Exchange?
A tax-deferred exchange is a transaction involving the sale and purchase of investment property or property held for productive use in a trade or business which meets requirements of Section 1031 of the Internal Revenue Code and qualifies for non-recognition of gain or loss. Technically, the exchange is tax-deferred, not tax-free, since the gain deferred in the transaction will be recognized on the ultimate sale of the replacement property received in the Exchange. During a tax-deferred exchange, the investor may not have constructive receipt of their exchange funds. Therefore, a Qualified Intermediary (QI) as an independent third party is needed to facilitate a 1031 Exchange transaction and hold the funds on behalf of the investor.
When structuring an Exchange, there are two critical time limitations that begin on the day the original property is sold. They are:
It is important to note that the identification period and the closing period do run concurrently, and make no concession for weekends and holidays.
In addition to the time limitations when completing an Exchange, investors must also consider the value requirement. There is a general rule of thumb used in order to meet the exchange value requirement for full deferral treatment:
“ANY CASH RECEIVED PLUS DEBT RELIEVED FROM THE RELINQUISHED PROPERTY MUST BE REINVESTED INTO THE REPLACEMENT PROPERTY.”
The only exception to the above is with the investment of new cash to replace any or all of the debt relieved. Additional debt, while allowed when acquiring a replacement property, does not get an exchanger to the value requirement if cash is withdrawn from the transaction.