1031 Exchanges: Top 4 Little-Known Uses

The 1031 Exchange is the section of the IRS code that allows an owner to replace their investment real estate property for another investment property, while deferring the capital gains tax liability until the re-sale of the 2nd property.  This has given real estate investors the ability to shelter cash flow but that’s not its only benefit. Here are 4 strategies investors can use the with the 1031 Exchange to secure their investments and diversify portfolios.

Reverse Exchanges

For most 1031 Exchange transactions, a property is sold and an investor has 45 days to locate another property with a total of 180 days to complete the exchange. Since this is not a huge window of time, some investors will locate the replacement property first. In order to secure it and not risk the chance of someone else buying it, the investor will enter into a reverse exchange.  The IRS states that in a 1031 Exchange the owner cannot hold title to the property sold and the replacement property at the same time.  An exchange coordinator will either go on title for the property being sold or the property being acquired.  This type of exchange has to be properly structured to avoid the obstacles that arise with having a third-party on title.

Partial Exchanges

A partial exchange is when an investor decides to have a portion of their capital gains tax deferred and accepts “boot” as the remaining portion. Boot refers to any property received in an exchange that is not like-kind. An investor may decide to take some cash out or reduce the replacement property’s debt.  Since the 1031 Exchange is only for the replacement of investment property for another investment property, cash boot and mortgage boot are not like-kind and the investor will realize a gain on these two items. In order to receive the boot the investor must instruct the closing officer how much cash they want from relinquished property’s closing and it will be received after the replacement property has been purchased.

Improvement Exchanges

An improvement Exchange allows an investor to construct or make repairs on a replacement property. It sounds simple until you consider the 180 day time constraint the investor has to complete the work. For any 1031 Exchange, the IRS states that the replacement property must be of equal or greater value to the property being relinquished. If an investor locates a property worth less than the property being replaced, the improvements will have to make up for the difference, in addition to being completed within the 180 day timeframe.  

Tenants in Common (TIC) Alternative

Owning a property in Tenants in Common means 2 or more people hold an undivided fractional interest in real estate property. In 2002, an IRS ruling qualified the TIC for the 1031 Exchange, which has increased its popularity. Replacing your investment with a TIC gives an owner the benefit of investing in a large property, and not having to deal with the property management of your asset.  Also, TICs are ideal for investors who are having a challenge locating their replacement property within the 45 day time constraint. 

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