You might have heard of the term “1031 Exchange” and be curious as to what it’s about. Successful real estate investors might want to learn more, considering that this exchange allows property owners to swap their current investment property for another. Normally, when your California investment property is sold, you’re obliged to pay the capital gain taxes. However, a 1031 exchange allows one to defer the capital gains taxes, provided certain conditions are met.
This article will cover the 1031 exchange in the state of California and how it’s useful to any property investor, such as yourself. It will contain definitions of the common terminologies surrounding the topic. However, for a more in-depth understanding, it’s advisable to consult a professional company that processes 1031 exchanges and can offer more critical insights on what mistakes to avoid during 1031 exchange transactions.
Defining a 1031 Exchange
The term originated from the US Internal Revenue Code’s Section 31. It essentially permits you to postpone the payment of the income tax upon selling one investment property. You can then reinvest the sales proceeds you received from selling your California home.
There are, of course, limitations in terms of time and type of properties. The 1031 exchange is only possible when you swap similar properties. They must hold the same value or a value greater than the current property you intend to exchange.
Importance of a 1031 Exchange
A 1031 exchange is looked on favorably by property owners for its opportunity to create more wealth. For example, you’re holding a property currently worth $300,000 that you bought for $50,000 a couple of years ago. If/when the California property sold, you’re required to pay capital gains taxes for the $250,000 profit.
Perhaps the capital gains tax will set you back $75,000. However, when you take advantage of a 1031 exchange, you can defer the tax. You can instead use the full $300,000 to buy more California properties without paying for capital gains from the transaction during that period.
The 1031 exchange benefits property owners by giving them breathing room. They can increase their real estate portfolio using the full income generated by the property sale. These real estate assets can be converted into rentals, adding more passive income.
Over time, the California unit also appreciates, making the investment worthwhile. To be clear, the capital gains taxes are not written off. However, most investors still exercise a 1031 exchange to purchase more valuable properties that will reward them financially.
Different Types of California Real Estate Exchanges
When it comes to a 1031 exchange, you have 4 options to choose from:
1. Simultaneous Exchange
As the term itself states, this type of 1031 exchange works if both the purchase and sale of the California real estate property coordinate on the same day. If delays occur either from the acquisition or sale, disqualification can result in paying for the capital gains tax.
Three ways for simultaneous exchange to happen:
- Swapping deeds with the other investment property owner
- Three-party exchange that includes an “accommodating party”
- Three-party exchange that includes a Qualified Intermediary (A Qualified Intermediary is a third-party company who can help you make sure you are doing everything correctly)
2. Delayed Exchange
Considered as one of the most common transactions, you need to sell your California home first before you can acquire another real estate investment. This is a popular type since you can use the proceeds from the sale of the property to purchase another. However, marketing and finding a solid buyer is required. You can engage in this type of transaction only when you complete the sale and final purchase agreement.
Note that you’re given 45 days to choose a new property and 180 days to complete the sale. Still, it gives the investor time, compared to the simultaneous exchange type of transaction.
3. Reverse Exchange
This process is unusual. You need to scout and buy a California home before the property you currently have on-hand is sold. Once you’ve acquired the new property, you still have time to sell your current property. You can then take advantage of market value appreciation while waiting to sell. (When the market value is higher than the price the investor paid for the property, this means there’s appreciation).
4. Construction or Improvement Exchange
This permits you to make substantial changes to the California property before the transaction pushes through. You have a period of 180 days to process the improvements.
Here are three requirements to fulfill to be free from capital gains tax:
- The entire exchange equity will be used as a down payment or on construction costs for the property improvements. This must be within the allocated 180 days.
- The same property chosen on the 45th day will be turned over to the taxpayer. The property is required to be equal or greater value than the original property after improvements have been made.
- Finished construction within 180 days.
Defining 1031 Exchange Terms
1. Like-Kind Property
This means that properties can be of similar nature. However, like-kind properties need not appear the same.
The term is actually broad and does not limit exchanges between ranches and apartment complexes. The only fixed requirement is that both investment properties must be located in the U.S.
For example, you can exchange an apartment building for a duplex.
2. Investment Property
This means you cannot use your personal property or home for a 1031 exchange transaction. Only a business or investment property, such as a single-family rental unit, can be qualified for swapping with a commercial building.
3. Boot
Boot refers to money, reduced debt or personal property you received in an exchange. It’s a non-like kind property. If you receive a boot in any form, you will not enjoy a full tax-free exchange.
4. Same Title Holder/ Taxpayer
Simply put, both the names on the property title of the relinquished property and the new replacement property must be the same.
(A relinquished property is also known as the “Downleg”).
Bottom Line
While savvy real estate investors maximize 1031 exchange for wealth building, you still need a professional for proper guidance. Special 1031 exchange rules apply that require a deeper understanding so you can enjoy a defer capital gains taxes.
When you work with East Bay Property Management and Consulting, you benefit from professional advice and knowledge of 1031 exchanges and other real estate terms. Contact us today!