Real Estate Companies: Defer Taxes With a 1031 Exchange
Following is an excerpt from MFA’s whitepaper, Strategies for Real Estate Company Growth & Opportunity.
Regardless of industry, businesses require thoughtful and strategic tax planning to maximize cash flow and allow for growth opportunities. For real estate investors and entrepreneurs, there are a number of tax provisions available to minimize business and investment tax liabilities while also developing opportunities to reinvest within the industry and set up future generations for financial success.
One tax strategy that can be deployed to help meet these goals is a Section 1031 Tax-Deferred Exchange.
1031 Like-Kind Exchanges
A “1031 exchange” derives its name from Section 1031 of the U.S. Internal Revenue Code which defers capital gains taxes in the event an investment property is sold and proceeds from the sale are reinvested in property of like kind and equal or greater value within a certain time period.
By deferring the roughly 20-to-30-percent capital gains tax that would apply to a conventional property sale, real estate business owners can recoup those payments and apply them to future investments, savings and/or an estate plan.
Investors can complete simultaneous 1031 exchanges (meaning the relinquished property and replacement property close on the same day) or deferred 1031 exchanges (allows an investor up to 180 days to complete the exchange after the sale). Both variants offer compelling use cases for real estate investors and entrepreneurs looking for a tax advantage.
Qualifying for a 1031 Exchange
Whether simultaneous or deferred, 1031 exchanges must include an exchange of property of a like-kind. Essentially, both relinquished and replacement properties must be of a similar nature, though the definition of ‘like kind’ is interpreted fairly broadly by the IRS.
That said, there are a number of items that do NOT qualify for like-kind exchanges, including:
- ‘Personal use property’, such as a primary residence or secondary home
- Non-U.S. investment properties
- Stocks and bonds
- Partnership interests
- Trust certificates
- Dealer inventory or stock in trade
Post-Tax Cuts and Jobs Act, the requirements for a 1031 exchange did become a bit more restrictive. For example, tax reform changes “eliminated exchanges of personal or intangible property such as machinery, equipment, vehicles, artwork, collectibles, patents and other intellectual property and do not qualify for nonrecognition of gain or loss as like-kind exchanges” according to the IRS.
Reasons to Consider a 1031 Exchange
A tax-deferred 1031 exchange offers a number of advantageous returns to a qualified real estate investor. You may want to consider a 1031 exchange if you’re looking to:
- Free up capital for a new property investment
- Improve your overall buying power with more leverage resulting from a more valuable investment property
- Build or enhance your estate plan, leaving your heirs to inherit real estate unencumbered by previously-deferred taxes
- Reduce your ongoing property management and maintenance (e.g. invest in a professionally-managed property or consolidate a growing property portfolio by exchanging for a single replacement property)
- Build equity over time through successive exchanges that continuously grow the value of your portfolio without diminishing investment capital through current tax exposure
- Build new replacement property with a valid construction exchange
Reach out to the experts at MFA to understand the full suite of advantages and disadvantages to leveraging 1031 exchanges.
Material discussed in this communication is meant to provide general information and should not be acted on without obtaining professional advice tailored to you or your company’s individual and specific needs. Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used by any person or entity, for the purpose of (i) avoiding penalties that may be imposed on any taxpayer or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. This information is for general guidance only and is not a substitute for professional advice.
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