Spectrus Real Estate – 1031 Exchanges
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- What is a 1031 exchange?
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Under Internal Revenue Code (IRC) Section 1031, a real property owner can sell certain property and
then reallocate the proceeds in ownership of like-kind property and defer the capital gains taxes.
To qualify as a like-kind exchange, property exchanges must be done in accordance with the rules set
forth in the tax code and in the treasury regulations. The 1031 exchange can offer significant tax
advantages to real estate buyers.
- Who should consider a 1031 exchange?
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If you have real property that will net you a gain upon sale (generally property that has been
substantially depreciated for tax purposes and/or has appreciated in fair market value), then you
are exactly the person who should consider a 1031 exchange.
- There are 5 tax classes of property:
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- Property used in taxpayer’s trade or business
- Property held primarily for sale to customers
- Property that is used as your principal residence
- Property held for investment
- Property used as a vacation home
Section 1031 applies to the first and fourth categories, and sometimes the fifth category. Business
use is defined as, "To hold property for productive use in trade or business." Property retired from
previous productive use in business can be qualifying property. Investment purpose is defined as real
estate, even if unproductive, held by a non-dealer for future use; or the increment in value is held
for investment and not primarily for sale. Investment is the passive holding of property, for more
than a temporary period, with the expectation that it will appreciate. Property held for sale in the
immediate future is not held for investment.
- Why should you consider a 1031 exchange?
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- Defer paying capital gains taxes. A properly structured exchange can provide real estate buyers with the opportunity to defer all or most of their capital gains taxes.
- Leverage.
- Upgrade or consolidate property.
- Diversify. Own multiple properties rather than just one.
- Relocation to a new area.
- Differences in regional growth or income potential.
- Change property types among commercial, retail, etc.
- What are the general 1031 exchange rules?
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The real property you sell and the real property you buy must both be held for productive use in a
trade or business or for investment purposes, and must be like-kind.
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The proceeds from the sale must go through the hands of a qualified intermediary and not through
your hands or the hands of one of your agents, or else all the proceeds will become taxable.
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All the cash proceeds from the original sale must be reallocated to the replacement property—any
cash proceeds that you retain will be taxable.
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The replacement property must be subject to an equal level or greater level of debt than the
relinquished property or the buyer will either have to pay taxes on the amount of the decrease or
have to put in additional cash funds to offset the lower level of debt in the replacement property.
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Disclaimer – There are substantial risks associated with the federal income tax consequences of
purchasing and owning real property, especially if the purchase is part of a tax-deferred exchange
under section 1031 of the code. In addition, the income tax consequences of purchasing and owning
real property are complex. Because the tax consequences are complex and certain of the tax
consequences may differ depending on individual tax circumstances, each prospective purchaser must
consult with and rely on his own independent tax advisor concerning the tax consequences of such a
purchase and his individual situation.
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