When you start looking for ways to maximize your cash flow and make strategic moves with your investment properties, knowing the ins and outs of a 1031 exchange will come in handy. These four tips will give you an idea as to how experienced real estate professionals and investors successfully navigate exchange scenarios to optimize their investments.
Avoid the boot
The basic rules of a 1031 exchange seem quite simple. Your existing, ‘relinquished’ property must be exchanged for a ‘replacement’ property of “like-kind.” The owner’s name on the title can’t change. And all proceeds from the sale must be reinvested – your replacement property should be equal or greater in value.
The first two are easy enough, but it’s the last part that causes many slip-ups. You can’t use exchange funds to pay for indirect costs such as broker commissions, inspector fees, mortgage tax, or to cover the value of goodwill in the exchange. If you do, this can be reported as a taxable capital gain, also known as the dreaded ‘boot.’
If you’re going to make the 1031 exchange work in your favor, a deliberate strategy is needed. Like any other investment, you want to evaluate the replacement property and how it fits with your priorities. For instance, many retirees getting into real estate investment for the first time will find it ideal to start with a tenant-in-common (TIC) property, so consult with a TIC investment company for favorable deals.
You should also remember to have a backup plan just in case things don’t work out. So if you’re relocating from Florida to Texas, for instance, you don’t have to look for replacement property located only in Texas. It could be anywhere in the United States, and you can still make money if maintenance costs are low and rental rates in your favor.
Vet your intermediary
1031 exchanges require you to use a qualified intermediary, a middleman, without a personal or financial relationship to you within the past two years. As they will be handling all paperwork and accounting, in addition to safeguarding the proceeds from your relinquished property, it’s vital to find the right middleman for the job. Note that some states don’t require licensing for intermediaries, so make sure to do your homework, read reviews and referrals, and find a reputable intermediary to smooth the exchange process.
Stay on time
The IRS has two firm deadlines involved when it comes to tax-deferred exchanges. First, within 45 days of selling your relinquished property, you have to identify – via written notice to your intermediary – the potential replacement property. Second, the replacement property must be acquired within 180 days of the sale of your relinquished property. And if Tax Day falls within the 180 days, the sale must be closed by that date instead. Don’t miss these deadlines, or else the entire transaction becomes taxable.
Keep in mind; there are times when you might not be able to play by these rules entirely. In reality, dealing with property buyers and sellers alike involves negotiation, and you may not get the values to match exactly on both ends. If you end up paying a tax of 20-35% on the goodwill of $100,000, for example, it can still wind up being a great deal when all else is considered. Make sure you consult with an industry expert to get an in-depth understanding of the exchange process and use it to your advantage.