Investing in Laguna Beach with a 1031 Exchange, Part 1

What is a 1031?

In a nutshell: Utilizing section 1031 of the US Internal Revenue Code is an effective strategy to defer any capital gains tax that may arise from selling investment property. By exchanging the real estate for like-kind property, owners and investors may defer some or all capital gains tax and use all of the proceeds to purchase a replacement property.

What are the Advantages?

• allowing you to produce a long-term, sustainable, growing income stream.
• potential liquidity with the ability to cash out your investment tax deferred
• gives the option of diversifying your holdings among multiple properties and partial interests

How Does it Work?

Savvy investors use 1031 exchanges to defer capital gains and build wealth. In real estate, a 1031 exchange is a swap of one investment property for another. IRS Section 1031 has many moving parts. And, real estate investors should take time to understand them before attempting its use. An exchange can only be made with like-kind properties. So, IRS rules limit use with vacation properties.

A 1031 exchange is a swap of properties that are held for business or investment purposes.

• Each property being exchanged must be considered like-kind in the eyes of the IRS in order for capital gains taxes to be deferred.
• If used correctly, there is no limit on how many times or how frequently you can do 1031 exchanges.
• The rules may apply to a former primary residence only under very specific conditions.

There’s no limit on how many times or how frequently you can use a 1031. You can rollover the gain from one piece of investment real estate to another, to another, and another. So, even though you may profit from each swap, you avoid capital gains taxes until you sell for cash years into the future. The idea is that you will only then pay “long-term” capital gains tax.

What Does Like-Kind Exchange Mean?

According to the IRS, most exchanges must merely be of “like-kind.” This is a somewhat enigmatic phrase that may not mean what you think it does. For example, you might exchange an apartment building for undeveloped land, or a farm or ranch for a strip mall. You might even exchange one business for another. But there are traps, so be wary.

The 1031 provision is for business property and investment. But, the rules apply to a former primary residence only under specific conditions. There are additional ways to utilize the 1031 rule for exchanging vacation homes, but this loophole is much tighter now than in the past. In order to qualify for a 1031 exchange, both properties must be located in the United States.

Depreciable Property has Special Rules

Exchanging depreciable property can trigger a profit known as depreciation recapture. And, it is taxed as ordinary income. For example, if you exchange one building for another building, you likely avoid recapture. However, if you exchange improved land that has a building for unimproved land with no structures, any depreciation you previously claimed on the building is recaptured as ordinary income. But, interests as a tenant in common (TIC) in real estate do qualify.

2017 Tax Cuts and Jobs Act Changes to 1031

Prior to the passage of the 2017 Tax Cuts and Jobs Act (TCJA), some exchanges of personal property (e.g., franchise licenses, equipment, or aircraft) qualified for a 1031 exchange. Today, only real property (or real estate) as defined in Section 1031 qualifies.

Stay tuned for part 2 in our next post.

If you are interested in an investment property or a 1031 exchange, let me know. Finding the right property advisor that fits your needs doesn’t have to be difficult. I am commercial-certified to help investors and have sold several duplex’s locally (2 very recently). Let me help you with your 1031 exchange.

Check out these potential investment properties on the market in Laguna Beach now.