In case you already know everything about taxes, then you might want to broaden your knowledge on a topic that includes tax deferring. You may have heard about like-kind exchanges before. This concept is used in the real-estate business field and it is also called a 1031 exchange. Such an exchange represents a method that allows people to swap a business / investment asset for another one. This method is often used by people who desire to change their working field (in the case of businesses) while deferring taxes. This is the biggest benefit of like-kind exchanges: there are either no taxes at all or limited taxes involved, making it very convenient. Changing a form of investment is now possible by using this type of exchange. Understanding how like-kind exchanges work and what type of rules are implied in the process is paramount if you plan on using one. Here are some tips and tricks that could help you out with 1031 exchange real estate processes:
Rules and regulations
Like-kind exchanges do not work with any type of property. Understanding all the requirements is paramount in order to succeed in completing a like-kind exchange. If you want to take advantage of tax deferral, your property should respect the following rules:
- The property you want to swap should be used for investments, trading or business. This is the only way to swap properties. The 1031 exchange won’t work with your own home or other personal properties that are not related in any way with the commercial domain. Yet, there are some exceptions that you can learn about later on. The properties that will be swapped should both generate income (either through rent or inventory). One cannot swap a personal property with a commercial one or vice-versa. Of course, the properties should be of similar value, as the name explains it: like-kind.
- Doing a like-kind exchange involves using a neutral third-party administrator. This neutral third-party administrator should prepare all the documents implied in the process, should provide both sides of the exchange with instructions to settle down and he also needs to hold all the proceeds coming from the relinquished property. This is required so that no issue is encountered between the taxpayer and the exchanger. Deferring the tax and maximizing your gains requires such a third-party administrator so you don’t have to deal with all the complicated financial steps that the exchange involves. This qualified administrator needs to be unbeholden and unrelated to either the taxpayer or the exchanger.
- There are some deadlines that need to be strictly followed. One of these deadlines – the 45-day one – is related to finding three (and sometimes more than three) replacement properties. The second deadline – the 180-day one – is related to purchasing the property. You can find different calculators on the Internet that can help you out know exactly when the 45th day and the 180th day is. Respecting these deadlines is absolutely essential because otherwise the transaction won’t be completed.
You have to understand that qualifying for depreciation deductions is the stepping stone of the like-kind exchange process. You have to find out if the property is tangible or intangible for this sort of exchange and – as mentioned before – there are specific rules that your property needs to respect. To summarize them and avoid forgetting any, follow this list:
- The property should be used in a business (to be income-producing)
- The property must be the one you have capital investment in
- The property should have a determinable future expectation
- The property should be stable enough to potentially produce income at least 12 months from the moment of the transaction
- The property must not be excepted
- Properties that are of personal use (homes of all types, automobiles etc.) cannot be depreciated
In the future, you might need to recapture the exact depreciation that were deducted by you in terms of real-estate investment properties. Depreciation recapture means that you are going to recapture / add-back the value of depreciation back in your taxable income. That happens when tax deferring strategies don’t work like they are supposed to.
There are several types of exchanges that you might want to know about:
- The delayed exchange
This type of exchange refers to the mentioned deadlines. The initial property is sold but the second one is not yet found for purchasing. This is where the third-party administrator intervenes, and the deadlines appear (the 45-day and the 180-day ones). Without respecting the deadlines, the transaction won’t be completed. This is the most common type of exchange. A like-kind exchange can rarely be completed simultaneously since finding similar-value properties is a time-consuming process.
- The built-to-suit exchange
Another popular type is the built-to-suit / the construction exchange. This type of exchange allows people to sell the first property if improvements / replacements are going to be involved in the second property using the money obtained from that initial property. This type of exchange is often used by people who desire to swap properties that are not of similar value and they are willing to invest in the property that requires some work.
- The reverse exchange
The reverse exchange is known as a parking arrangement and it occurs when the second property involved in the exchange is already purchased and the proceeds of the initial property are applied in a retroactive manner. Basically, it includes the same process as in a regular 1031 exchange, but the order of selling and purchasing is different. The only reason why a reverse exchange is more complicated than a regular one would be the requirement of an EAT (Exchange Accommodation Titleholder) to hold the replacement property until the purchaser sells the first one.
The exception: personal property exchange
Personal goods can be swapped if investment purposes are involved. Personal properties cannot be exchanged for real estate, but investors who desire to swap personal goods in order to update their actual income-producing business can do that in order to benefit from tax-deferral.