For individuals who plan tobuy and sell real estate as along-term asset or retirementstrategy, it's worthunderstanding the 1031exchange. Also known as "like-kind"exchanges, 1031 exchanges allow aninvestor to defer capital gains taxes ifthey sell a big asset, such as a rentalvacation home, and invest the proceedsimmediately in a similar asset. Theadvantage is that the investor can delaytax consequences when upgrading theinvestment property they own.
How 1031s Got Started
Named for their place in the US taxcode, 1031 exchanges were created inthe 1920s for businesses and big-leagueinvestors who owned many assets. Untila few years ago, those groups were stillthe main customers for 1031 transactions,but skyrocketing real estate valuesand the rising number of baby boomersheaded for retirement have made 1031exchanges popular for small investors,too. However, these are complex transactionsand almost always require assistancefrom tax advisors and intermediariesrequired to facilitate each deal.
1031 exchanges have strict timeframes for buying and selling real estateif the exchange is not simultaneous, soit's important to find a broker and taxadvisor who understand exactly howthese transactions work. The simplestform of a forward 1031 exchange workslike this: A person with available propertyidentifies a property of like-kind valuefor an exchange. Because of the IRS'sbroad definition of like-kind, the propertydoesn't have to be identical or for theexact same purpose—in other words, asix-unit apartment property could beexchanged for a warehouse, strip mall,or even undeveloped land. Under thebasic rules of 1031 exchanges, investorshave 45 days to identify up to threeproperties of equal or greater value thatthey plan to exchange for the old oneand a total of 180 days to close the deal.1031 exchange transactions require theinvolvement of a third-party intermediaryto hold the money while theexchange is done so the tax advantagedoesn't evaporate.
A reverse exchange allows thereplacement property to be purchasedand closed on before the relinquishedproperty is sold. Usually the intermediarytakes title to the replacement propertyand holds title until the taxpayercan find a buyer for their relinquishedproperty and close on the sale under anexchange agreement with the intermediary.Subsequent to the closing of therelinquished property (or simultaneouswith this closing), the intermediaryconveys title of the replacement propertyto the taxpayer.
Properties that don't qualify under a1031 include a personal residence; landunder development; construction orfix/flips for resale; property purchasedfor resale; inventory property; and corporationcommon stock, bonds, notes,and partnership interests. Also, someonemay be disqualified if they don't handletheir 1031 strategy properly. A physician-investor who buys and sells frequentlymay be declared a dealer of realestate and be subject to ordinary incometaxes instead of capital gains.
Is there an easier way to buy realestate? Qualified commercial real estateagents are often good at continuallyspotting properties that would qualifyfor a 1031 exchange. But keep in mindother alternatives that may save moneyin brokerage costs. Major retailers thatdo a good job of scouting locationsmay also have an outreach function forattracting individual investors for syndicatesformed to own their real estate.This type of ownership can also bedone as a 1031 strategy, with the rightadvice. Even the most established realestate opportunities have risks.
Keep abreast of the tax code. Even ifa physician-investor doesn't have thatmuch expertise in tax matters, it's importantto have a basic understandingof the tax issues that affect real estatetransactions. The IRS Web site (www.irs.gov) is a good bookmark to helpstart that education.
This article has been produced by the Financial Planning
Association (www.fpanet.org), the membership organization
for the financial planning community.