Capital gains in the United States are subject to tax when realized. As a real estate investor, this includes capital gains realized on property sold or exchanged. If you have sold or exchanged property resulting in any capital gains, you would be expected to report such gains in your tax return. However, you may be able to elect for a capital gains tax deferral if you opt to reinvest in like kind property or designated opportunity zone communities.
Two popular property investment vehicles that encourage long-term real estate capital investments are the 1031 Exchange and the Qualified Opportunity Fund (QOF). They spur up investments by providing capital gains tax incentives on the sale or exchange of property investments. The underlying concept behind 1031 exchanges and QOFs is the opportunity to defer taxes when capital gains from property sale are reinvested in property using either of these vehicles.
Qualified Opportunity Funds and 1031 exchanges operate with different requirements. While they arguably serve diverse purposes, the tax advantage associated with these two investments vehicles spur up real estate investments. Here's what investments in QOFs and 1031 exchanges entail.
The 1031 exchange gets its name from the Internal Revenue Code (Section 1031) which introduced a tax incentive for property capital gains when reinvested in a like kind property. This type of investment is sometimes referred to as a 1031 like kind exchange. When considering real estate investments through 1031 exchanges, it is important to be aware of the underlying rules that make your transaction qualify for capital gains tax deferral. Any mistakes may disqualify your property exchange transaction from being considered as a 1031 like kind exchange.
When you make a property sale, you’ll need to identify the reinvestment property within 45 days from the sale or exchange of your relinquished property. The new property or properties would need to be of like kind nature with the relinquished property. You will also be expected to make this reinvestment within 180 days from the sale of your relinquished property.
An important part of the 1031 exchange is using an intermediary to facilitate the exchange of properties as this cannot be done directly.
An important factor in a like kind exchange is the value of properties being exchanged. If the sale proceeds of the disposed property exceed the fair market value of the new property or if there is any exchange that is not considered like kind in nature, this can result in capital gains being realized. These capital gains would be subject to tax.
The tax incentive through investments in a Qualified Opportunity Zone was introduced by the Tax Cuts and Job Act (TCJA) in 2017. Real estate investors can contribute to economic development by investing in Qualified Opportunity Zones (QOZs). In return, investors get tax advantages on eligible capital gains invested in these distressed communities.
When you invest capital gains in a Qualified Opportunity Fund, you may be eligible for tax deferral subject to all requirements being met. One key requirement is that the investment of capital gains must be made within 45 days from the date which the property is disposed and gains are realized. Also, it is important to note that the ownership interest in QOFs should be equity and not debt. For qualified investments in a QOF, capital gains tax can be deferred until the earliest of when sold or by December 31, 2026.
Asides a capital gains deferral, you may be able to reduce taxes on capital gains by 10% if you hold an investment in a QOF for at least 5 years. If your holding in a QOF is held longer for at least 7 years, your capital gains tax may be reduced by 15%.
The great part about property investments in a QOF is that investors may be eligible for a total tax elimination on capital gains realized from the disposal of your qualified investment in a QOF.
While the best capital gain reinvestment decision would depend on specific situations and the best optimal wealth management strategies, here’s what to consider when exploring capital gains reinvestments in either a 1031 like kind exchange or a Qualified Opportunity Fund.
Flexibility:
The flexibility of investing in either a Qualified Opportunity Fund or a 1031 exchange varies and may suit different investment goals. Investments in Qualified Opportunity Funds have to be in communities designated as QOZs while for 1031 exchanges, properties exchanged need to be of like kind in class and nature. As an investor, whatever option you decide to invest through would be limited based on these restrictions.
Also, Investments in QOFs are more flexible and can be done directly without the need for an intermediary. 1031 exchange investments on the other hand require the use of an intermediary. A property reinvestment is only deemed a qualified transaction for a 1031 exchange when property exchanged is carried out through a third party called a facilitator or an intermediary. The facilitator is responsible for collecting and transferring the sale proceeds as well as the reinvestment property.
Tax deferral:
While capital gains investments in 1031 exchanges and Qualified Opportunity Funds provide incentives for tax deferral, tax deferrals for QOFs are time sensitive. Tax deferrals from reinvestments in QOFs are on the earlier of a sale or exchange of a qualified investment or December 31, 2026. There are therefore uncertainties around this benefit for investors who need to hold their investments for longer.
In comparison, an eligible tax deferral on 1031 exchange investments comes into effect at any time of disposal of the reinvested property.
Tax elimination:
There is the possibility of tax elimination with investments in Qualified Opportunity Funds. This elimination may only be applicable after 10 years of holding qualified investments in a QOF and it is applied on the capital gains from sale of the interest in a QOF. An investment in property through a 1031 like kind exchange would usually not allow for tax elimination of gains after property sale or exchange.
Timeline:
One of the key rules for a capital gain reinvestment in property to qualify as a 1031 like kind exchange is that the new property has to be identified within 45 days after the sale or exchange of the disposed property. In addition to this rule, the sale or exchange of properties needs to be done within 180 days from the sale or exchange of the disposed property.
The requirements for investments in Qualified Opportunity Funds does not include a property identification timeline , however, the Internal Revenue Service (IRS) requires that reinvestment of capital gains are done within 180 days from when they are realized.
Reinvestment value:
The basic rule for capital gains reinvestments to qualify as a 1031 exchange is the reinvestment in like kind property. Any reinvestments in property that does not qualify as like kind or property with market value below the relinquished property may result in gains that are subject to tax. In this case, the entire principal and capital gains from a property sale may need to be fully reinvested to benefit the full tax deferral advantage.
For Qualified Opportunity Funds, there is no requirement to reinvest the principal from property sale. You can benefit from the tax deferral incentive that comes with investing in a Qualified Opportunity Zone by only reinvesting the capital gain from your disposed investment.
Capital gains:
Capital gains deferral through a DST are realized through property sale or exchange, while capital gains deferred through a QOF can be gotten through other forms of investment like stocks or bonds. This provides more opportunities for investors looking to manage their capital gains tax from a broader range of investment portfolios.
Qualified Opportunity Funds and 1031 exchanges provide means for managing capital gains tax. Both vehicles have tax advantages when certain rules and requirements are met. A 1031 like kind exchange may qualify for tax deferral and a holding in a QOF can lead to capital gains tax deferral, reduction or even elimination.
The decision to use either a 1031 exchange or a QOF is dependent on specific investment goals as well as preference. You can choose one vehicle over the other based on the flexibility of your investment transactions or the location of investment property that suits your preference.
Also this decision may be made based on the need to take advantage of possible tax reduction or elimination on property capital gains. Both investment vehicles are available to accredited investors who are deemed financially sophisticated to invest in non-publicly traded investments. The nature of investments in QOFs and 1031 exchanges make them complicated alternative investments and thus require assessment and advise from tax experts or investment advisors .
Finding the best investment partner as a real estate investor is very important. The best investment partner is one that works with you to understand the different investment options you have and provide effective investment strategies to help you reach your goals. Stax Capital provides years of experience and professionalism in alternative real estate investments. You can explore property investments through a 1031 exchange with Stax Capital. The Delaware Statutory Trusts vehicle offered by Stax Capital qualifies as 1031 like kind exchange through which you can reinvest your capital gains from property sale. We also offer real estate opportunities through Qualified Opportunity Funds that may be eligible for capital gains deferral, provided all requirements are met.
The 1031 exchange is a term that comes up often in the real estate world of investing. For property investors, the 1031 exchange can be used as an important tool to manage capital gains taxes on property sale.
The process of a 1031 exchange requires professional expertise to execute properly. While it may be considered an advantageous route in property investment, the 1031 exchange does not make capital gains from property sale tax free but rather, tax deferred.
Here’s what you should know about investing in properties using the 1031 exchange.
The 1031 Exchange originated from the Internal Revenue Code (IRC), section 1031, which refers to the exchange of property held for productive use or investment.
Whenever you make a gain from the sale of an investment or business property and reinvest the sale proceeds in a like-kind property, the 1031 exchange allows you to defer taxes on the capital gain.
However, when you eventually sell the reinvestment property, the deferred capital gain from the disposed property plus any additional gain from the replacement property would be subject to tax.These property investment transactions are of a complex nature and thus require the collaboration of various parties such as the investor, who is usually a taxpayer, a facilitator, a tax expert, an investment company, amongst others.
For an investment property sale and purchase transaction to qualify as a 1031 exchange, it has to meet various requirements and follow some laid out rules.
If the possibility of not paying taxes on capital gained from a property sale sounds too good to be true, it is because it comes with a number of rules that have to be adhered to.
One major rule is this, the replacement property, also known as the reinvestment property, has to be identified within 45 days of the sale or transfer of the relinquished property (the property to be sold).
Also, importantly, the replacement property has to be received by the earlier of 180 days after the relinquished property has been sold and transferred or the due date of the investor’s tax return for the taxable year in which the relinquished property is transferred.
To qualify as a 1031 exchange, the sale proceeds of the relinquished (disposed) property investment cannot go directly to the owner of the property. The sale proceeds for a 1031 exchange has to go through a qualified intermediary or an exchange facilitator.
Qualified intermediaries are third parties to a 1031 exchange transaction, they usually have no formal relationship with the seller of the investment property or the owner of the new property to be invested in.
The qualified intermediary facilitates the sale by receiving the proceeds from the 1031 exchange and transferring it to the seller of the replacement property (reinvestment property).
As an investor, you have to sell and reinvest in like-kind properties for the 1031 exchange advantages to come into effect. The disposed property and the new property to be acquired have to be like-kind, meaning, the properties have to be alike in terms of nature and character and not necessarily by quality or grade.
Also, the value of the replacement property should be of greater or equal value to that of the relinquished property for the transaction to qualify for tax deferral.
If the value of the replacement property is higher than the value of the disposed property, this may result in a boot. When this occurs, the boot becomes taxable. Proceeds that are not considered to be like-kind property exchange would be subject to tax.
Properties involved in a 1031 exchange have to be located within the United States.
1031 exchanges can be carried out using a simultaneous swap, delayed or deferred exchange, a reversed exchange or an improvement property exchange.
Using a simultaneous 1031 exchange, real properties are exchanged simultaneously, no delays or deferrals.
With the deferred 1031 exchange, the relinquished property which the investor wants to sell is transferred first and the reinvestment property to be acquired is then identified within 45 days after the transfer. The exchange should be completed within the 180-days time limit.
In order to qualify as a 1031 exchange, this type of like-kind exchange needs to be differentiated from a transaction that’s basically just using the sale proceeds of a property sold to buy another property.
The reversed 1031 exchange involves an investor acquiring the replacement property first before selling the relinquished property. This type of exchange would be possible if the investor has cash or a facility to acquire the new investment property.
The replacement property is usually acquired through an exchange accommodation titleholder. This exchange also needs to meet the 180-days rule to qualify as a 1031 exchange.
An improvement property exchange involves using the proceeds from a relinquished property to improve the replacement property of choice. However, the 180-days rule from the sale of the disposed property still applies. Properties exchange also still need to be of the same fair market value.
For a 1031 exchange, you may need to prove that the transaction is indeed an exchange of property. You have to show that the sale of the relinquished property and the purchase of the replacement property are integrated and mutually dependent on each other.
The major advantage of real estate investments using the 1031 exchange tool is the ability to defer capital gain taxes on proceeds from real estate property sale.
As an investor, you may be able to carry over any gain from sale proceeds that have been reinvested in a like-kind property for years with no tax implication until you finally decide to sell the newly acquired property.
When you invest in new properties using the 1031 exchange, you may have more purchasing power and more retained cash because there is no immediate cash outflow that would have occurred as a result of taxes on capital gains.
Only real properties qualify for tax benefits through a 1031 exchange. The property purpose rule is one that has to be met. The exchanged properties in the 1031 exchange should be for trade, investment or business purposes and not for personal uses such as a vacation home or property used as a primary residence or second home.
Properties held primarily for resale do not qualify for 1031 exchanges, this may include properties sold immediately after they are acquired, or properties improved for the sole purpose of resale such as a fixer upper.
Examples of properties that can be leveraged for the 1031 exchange include: retail properties, commercial properties or buildings, rental properties, industrial properties, apartment buildings, etc.
The real properties that qualify as like-kind can either be improved or unimproved.
Corporations and partnerships, trusts, limited liability companies (LLCs) and other entities that pay tax may be able to set up a 1031 like-kind property exchange.
The Delaware Statutory Trusts (DSTs) is a vehicle that can be used to take advantage of any tax deferral that may result due to reinvestment in like-kind property. In other words, DSTs qualify as 1031 like-kind property exchanges.
To identify DSTs to reinvest in through the 1031 exchange within 45 days after the sale of the relinquished property, you can use the three-property rule, the 200 percent rule and the 95 percent rule.
Using the three-property rule, you can identify up to three prospective replacement properties irrespective of their fair market value.
With the 200 percent rule, you can identify any number of prospective replacement properties given that the total market value of these properties does not exceed 200 percent of the fair market value of the disposed property by the transfer date.
A 1031 exchange may still be in effect if the accredited investor identifies unlimited prospective replacement properties as long as 95 percent of the total value of all identified properties is purchased.
While DSTs may possess liquidity risk, they may provide a faster route for you to identify and close on property investments that qualify as 1031 exchange under the 45-days and 180-days like-kind property exchange requirements.
For over 12 years, Stax Capital has offered real estate investments that qualify as 1031 like-kind exchanges. With investment properties under Stax Capital DSTs, you gain access to top notch management that relieves you of the complexities and time-consuming nature of managing investment properties.
If you need to diversify your investment portfolio through the real estate market, the highly experienced team at Stax would work with you to provide solutions and opportunities that may potentially expand your portfolio and help towards your wealth generation goals and objectives.
For when you need to invest in a property that qualifies as a 1031 like-kind exchange but want to stay away from the hassles of property management with the potential to earn passive income, Stax capital is just a reach away.
Delaware Statutory Trust vehicles are only available to accredited investors. Property investments using the Delaware Statutory Trust vehicle as a 1031 exchange can be a complex process, therefore, it is advisable to get professional advice from tax and investment advisors.
In life, success can come in different ways. One of the biggest successes a person can achieve is building something that will benefit not only you but also the generations that follow. Doing so ensures that with each generation, the path to success is much easier. This can be accomplished by using DSTs.
Over the years, real estate has proven to be arguably the best sector for multigenerational wealth. However, as much as it is lucrative, it comes with its own set of challenges regarding property management. This is why investors choose to use Delaware Statutory Trusts (DSTs). These are investment vehicles that allow people to become passive real estate owners.
More importantly, they allow investors to diversify and reduce risk as investors benefit from anonymity and lawsuit protection. Due to the enticing nature of DSTs, the sector has been growing significantly in recent years. In 2017, DST investments totaled $1.97 billion, which would rise to $2.57 billion in 2018.
Ordinarily, after selling property, you are required to pay taxes. One of the key advantages of DSTs is that they enable you to capitalize on Section 1031 of the IRS code. Under this code, real estate investors can defer capital gains taxes. This is achieved by reinvesting the proceeds of the sale into one or up to three properties of equal or greater value. Doing so allows you to build wealth for you and your beneficiaries without incurring tax costs.
However, the IRS has very strict rules that must be followed in order to qualify for tax deferral. As a result, the process is complex, stressful, and time-sensitive.
Do you want to build wealth through a DST? Read on to find out the key steps you should be following to protect and grow your portfolio.
For real estate investors, tax-deferred 1031 exchanges are a tremendous opportunity. However, as with all other investments, it carries risk. If you make any mistake in the process, the 1031 exchange may fail. At times, due to these restrictions and eagerness of investors, the replacement property purchased may not be suitable for your goals.
Before you go down this path, it is important to first determine if it is suitable for you. Some of the things to consider include liquidity needs, the structure of property ownership, market conditions, potential tax liability, financial and lifestyle aspirations, and debt considerations.
To get a clear picture of the sector, and determine whether it's right for you, schedule an appointment with an investment consultant experienced in 1031 DST Exchanges.
The whole idea of building wealth through DST exchanges is based on the premise that property appreciates in value, and you will turn in a profit after the sale. Along with the profits, you can also use the potential capital gains taxes to reinvest.
If you are just starting, you will have to identify a suitable property to buy. Ideally, you should look for an undervalued property or one that you can remodel and sell at a profit. There are also other strategies you can use depending on your goals.
Once you feel the property is ready and can turn in a good profit, have it listed for sale. In the listing paperwork, your realtor will include your desire for a 1031 exchange.
As you know, there are strict measures to follow for a 1031 exchange to be successful, and there is a timeline. After selling your property, you have 45 days to identify one or a maximum of three replacement properties.
Three requirements should be met for a 1031 exchange to be eligible. These are:
Also, to ensure that the purchase can be linked to the sale, you only have 180 days to make the purchase to complete a 1031 exchange. Therefore, once you put your property up for sale, begin the search for replacement properties as time will be of the essence.
The primary goal of a 1031 exchange is to avoid capital gains taxes to boost your reinvestment kitty. With a fixed timeline for achieving this and rigid requirements, it is imperative to have a comprehensive transition plan in place.
Creating such a plan will reduce the chances of mishaps occurring along the way that will put the exchange at risk. And, even if something were to come up, you will be better prepared.
Considering that your goal is to build wealth for your beneficiaries and the complexities of 1031 exchanges, you should have a reliable team to help you with the process. Such a team should comprise at least an estate planning attorney, a CPA, and a financial advisor.
Each brings experience in different fields that are crucial for a 1031 exchange. To ensure everything goes according to plan, always consult with your team before making key decisions.
Once you find a suitable buyer for the relinquished property, enter into a contract with them. This will free you up to proceed to the next steps of the process.
As per IRS requirements, for a 1031 exchange to take place, a qualified intermediary must be involved. The intermediary's role, also known as 'accommodator' or 'facilitator,' is to ensure that it is the proceeds from the relinquished property that will fund the purchase.
After the sale, it is the qualified intermediary will receive the funds. They will hold on to the funds until a suitable property is identified. For the process to be eligible, you must open an exchange with a qualified intermediary before the relinquished property is sold.
Remember, after selling the relinquished property, you will only have 45 days to identify a replacement property. After this period elapses, there will only be another 135 days to close the deal. Even if everything seems to be going smoothly, ensure that the transaction is completed as soon as possible.
After the 1031 exchange process is completed, notify your tax advisor. This will ensure that they can prepare property tax forms accordingly. If a 1031 exchange spills over into the next tax year, wait until the process is over to file your annual taxes. However, you should file for an extension for filing taxes.
There are very little costs involved with 1031 exchanges, especially if you factor in the taxes you will save. Being a real estate transaction, you can expect the usual cost involved with buying and selling property.
The only unique cost you will incur is that for paying the qualified intermediary. Costs associated with qualified intermediaries include legal reviews and brokerage fees. All such costs involved with the exchange should be defined before the process begins.
Deferral of taxes is the primary benefit that comes with 1031 exchanges. Some of the taxes you will be able to defer include:
However, tax deferral is not the only benefit you will get from 1031 exchanges. Others include:
Other than being an efficient investment vehicle, DSTs are great tools for managing beneficiaries. To begin with, you will have full control as to who gets what and at which proportion. Should anything change over time, you can make adjustments as you deem fit. This includes adding new beneficiaries or removing others.
Thanks to the flexibility and high degree of control, it is easy to divide beneficial interests, which can even be issued for minors. However, in the case of minors, a legal representative must be appointed.
Another key benefit of DSTs comes in the form of asset protection. The compartmentalized approach to owning property ensures that risks do not spill over to other assets. Also, your personal assets will be protected, and you will also be protected from lawsuits.
Should things go as plan, you can generate significant wealth for you and your beneficiaries using a DST. However, there are crucial elements that will come into play. First, you need to have clear objectives and a well-defined strategy for achieving them. This should be accompanied by a sound investment partner to help you make the right choices.
Are you looking for quality investments to increase your nest egg? Stax Capital is a company specialized in alternative investments. Reach out to us today to learn more about the investment opportunities available.
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