The 1031 exchange is a powerful strategy that allows you as a real estate investor to defer the payment of capital gain tax when you sell an investment property for reinvestment in a similar one. In simple words, it allows you to postpone the taxes as long you reinvest the proceeds from the sale in a similar property. Other than the tax benefits, savvy investors execute 1031 exchanges to diversify their portfolios, invest in properties with better return prospects, and build their wealth.
Strict rules and specific timelines govern a 1031 exchange, so it’s best to seek professional help from a qualified intermediary when considering such an investment. Let’s evaluate some of the commonly asked questions about a 1031 dst investment.
What is the meaning of like-kind property?
Under section 1031 of the internal revenue tax code from which the 1031 exchange is derived, the like-kind property is a property of similar nature, class, or character regardless of quality. According to the internal revenue service, both the relinquished property (property being sold) and the replacement property must meet some requirements.
Both properties must be for business or investment purposes. A real estate asset is similar to another real estate asset. Some of the assets excluded from a 1031 exchange include:
- Partnership interests.
- Stocks and bonds.
- Certoficates of trust.
- Stock in trade or inventory.
- Debt and other securities.
Can you buy more than one replacement property in a 1031 exchange?
The answer is yes; you can purchase more than one replacement property in a 1031 exchange. However, there are restrictions. There are three identification methods when executing a 1031 exchange:
- The three property method allows you to identify up to three replacement properties, and you can buy one, two, or three properties.
- The 200% of fair market value method allows you to identify any amount or replacement properties as long as their full fair market value is not above 200% of the fair market value of the old or relinquished property.
- The 95% identification exception method allows you to acquire more than three properties over 200% of the relinquished property’s value as long as you acquire 95% of the value of the properties you identify.
How do you know the tax basis of the new property?
You must adjust and monitor the tax basis correctly to comply with the rules of the 1031 exchange. Bear in mind that the tax is not forgiven but instead deferred. The IRS states that when you sell the replacement property via a regular sale and not a 1031 exchange, the initial deferred gain plus any additional gain you realize when selling the replacement property is subject to tax. So you have to keep track of your basis on the newly acquired property.
Is your potential tax liability based on equity or taxable gain?
Your tax liability is based on taxable gain and not equity. You can engage a real estate attorney or a qualified CPA to help you calculate your taxable gain.
Engaging a 1031 exchange expert is best when considering a 1031 exchange investment.