What Can be Purchased Using a 1031 Exchange?

A 1031 exchange is a tax strategy based on Section 1031 of the Internal Revenue Code. It allows taxpayers to defer capital gains taxes by selling an investment property and reinvesting the proceeds into another asset. The exchange has strict rules regarding timelines but offers flexibility in terms of eligible properties.

How does it work?

A 1031 exchange is a tax strategy that allows investors to defer the payment of capital gains taxes when they sell an investment property and reinvest the proceeds in "like-kind" property. The concept of a 1031 exchange derives its name from Section 1031 of the Internal Revenue Code. By following the rules and guidelines established by the IRS, investors can take advantage of this tactic to potentially save significant amounts of money on taxes.

One of the key aspects of a 1031 exchange is the definition of "like-kind" property. The IRS broadly interprets this term, allowing for exchanges between different types of commercial properties. For example, an investor could sell a multifamily housing complex and reinvest in self-storage facilities, or sell raw land and purchase an office building. However, it's important to note that a primary residence cannot be exchanged for an investment asset under the provisions of a 1031 exchange.

Requirements for Investors.

To successfully execute a 1031 exchange, investors must comply with several important requirements. One key requirement is adhering to a strict timeline. After selling the original property (referred to as the relinquished asset), investors have 45 days to formally identify potential replacement properties.

Formal identification involves notifying a Qualified Intermediary, who oversees the transaction and manages a separate account for the proceeds. The identified replacement properties must fall under one of the following options:

Three-property rule: Investors can identify up to three potential replacement properties without any limit on their combined value. They have the flexibility to purchase any one property or a combination of the identified options.

200% rule: Investors can identify an unlimited number of potential replacement properties as long as the combined value does not exceed 200% of the sale price of the relinquished asset. This rule is beneficial for investors looking to downsize their holdings by acquiring smaller value properties.

95% rule: Investors can identify any number of properties, but they must acquire a combination of properties that equals at least 95% of the combined value. This rule is less commonly used and may decrease the chances of a successful exchange.

Adhering to these requirements is crucial for investors seeking to take advantage of the tax benefits offered by a 1031 exchange.

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After the identification process, the investor must complete their transaction within a total period of 180 days, including the initial 45-day identification period, in order to defer the payment of taxes. The Qualified Intermediary, responsible for overseeing the exchange, maintains transaction documentation and transfers funds from the separate escrow account to the sellers. Importantly, the taxpayer must not have access to the funds during the exchange process.

While a 1031 exchange defers capital gains taxes rather than eliminating them, this strategy can be used repeatedly. For instance, if an investor performs a 1031 exchange and later sells a property without utilizing the exchange, they will owe the deferred taxes. However, they can continue to employ the exchange method to swap properties in subsequent transactions. When the investor ultimately passes the last property to an heir, the heir receives it at the stepped-up value, effectively eliminating previous deferred tax obligations.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

·     There’s no guarantee any strategy will be successful or achieve investment objectives;

·     All real estate investments have the potential to lose value during the life of the investments;

·     The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;

·     All financed real estate investments have potential for foreclosure;

·     These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

·     If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

·     Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Can Banks Facilitate 1031 Exchanges?

A 1031 exchange can be a useful financial strategy for investors to maximize their gains and keep investing. The process involves selling a real estate asset that has appreciated, and instead of paying capital gains taxes on the profit, the investor uses a 1031 exchange to reinvest the proceeds into a "like-kind" property. This allows the investor to defer taxes on the appreciation until they sell the new property.

Under the 1031 exchange regulations, the IRS permits a wide range of business properties to be used as replacements. This means that an investor can exchange their appreciated real estate asset for a "like-kind" property, such as replacing a residential rental property with an office space, or swapping retail assets for industrial property or farmland. However, the entire value of the sold property, including any debt, must be replaced.

During the exchange period, which is typically delayed and managed by a Qualified Intermediary, the investor cannot access the sale proceeds. Additionally, the exchange process has strict deadlines, such as identifying potential replacement properties within 45 days and completing the transaction within 180 days.

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By conducting 1031 exchanges successively, an investor can continuously defer capital gains taxes that accrue with each exchange, provided that the property is held for at least a year each time. If the investor chooses to continue this practice indefinitely, they can eventually distribute the assets to their heirs without being subject to capital gains taxes. Upon the grantor's death, the heirs would receive the property on a stepped-up basis, resulting in no capital gains taxes being due.

Can I rely on my bank for guidance on 1031 exchanges?

Executing a successful 1031 exchange can be a complex process with a tight timeline. The stringent requirements for identifying replacement properties, coupled with the fact that the investor cannot access the funds during the process, make it a significant challenge. In some cases, mortgage amounts or improvement plans can further complicate deals. For instance, if the investor needs to improve the replacement property, the 180-day timeline becomes a limiting factor.

Given the complexity of 1031 exchanges, it's essential to engage an expert to assist with the transaction. While some banks offer the service, most large banks do not have much experience in this area. However, Wells Fargo is an example of a major bank that provides this service.

One potential advantage of using your bank is that you may already have a trusted adviser and easy access to your accounts. However, it's important to note that the bank with which you conduct other banking services might be disqualified from serving as your Qualified Intermediary, which is a crucial part of the 1031 process.

To ensure a smooth 1031 exchange, it's best to work with an experienced Qualified Intermediary who specializes in facilitating these transactions. They can help you navigate the rules and regulations, identify suitable replacement properties, and manage the funds during the process. It's also wise to seek advice from a tax professional to ensure that you understand the potential tax implications of the exchange. By doing your due diligence and enlisting the right professionals, you can successfully execute a 1031 exchange and leverage your investment gains to continue growing your portfolio.

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Can a Bank be Disqualified as a Potential QI?

When it comes to choosing a Qualified Intermediary (QI) for a 1031 exchange, it's important to note that the IRS doesn't provide explicit qualifications. Instead, the code outlines who may not serve as a QI. This list includes the investor, any family members, employers, employees, and agents. The "agent" exclusion specifically lists attorneys, accountants, real estate brokers, investment brokers or bankers, and tax advisors.

Banks are not specifically excluded from serving as a QI, but there are some factors to consider before choosing your bank for a 1031 exchange. First, if you have conducted business with the bank in the most recent two-year period, it may be disqualified from serving as your QI. This is because the IRS wants to ensure that the QI is a neutral third party with no personal or business relationship to the investor.

Additionally, while some banks offer 1031 exchange services, it's important to note that not all banks have experience with this complex process. Even if you have a trusted advisor at your bank, they may not have the expertise necessary to ensure a successful exchange.

Ultimately, choosing a QI is a critical decision for any investor pursuing a 1031 exchange. While using your bank may seem convenient, it's important to carefully consider the potential risks and benefits before making a decision. It may be wise to consult with a qualified 1031 exchange expert to ensure that you are making the best choice for your specific situation.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

When a 1031 Exchange Could Require a Shorter Exchange Period

Per Internal Revenue Code (IRC) Section 1031, an exchanger has 45 days to identify a replacement property and 180 days to close on it – both timelines commence the day the investor closes on the relinquished property.

However, if an investor closes on the relinquished property between October 18 and December 31, 2022, the timelines are shortened.

Per Section 1031 (a)(3)(B), the replacement property must be purchased by the earlier of two possible dates:

-      180 days after the date the relinquished property is transferred in the exchange, OR

-      the due date (as determined with regard to extensions) of the taxpayer’s return for the taxable year in which the relinquished property is transferred.

What to Know If Selling Real Estate After October 18, 2022

Section 1031 (a)(3)(B) states that investors selling real estate after October 18, 2022 – regardless of the 180-day rule – must close on their replacement property on the due date of their tax return, April 17, 2023.

For example, an investor who sells a multifamily property on December 5, 2022, must identify a replacement property 45 days later, by January 16, 2023. With the 180-day rule, the investor can assume they have until May 31, 2023, to close on the property. However, Section 1031 (a)(3)(B) shortens this exchange period, and the investor must close 33 days prior to the assumed date.

How to Extend the 180-Day Period

Those with a prospective shortened exchange period for their close can file an extension for their 2022 return, expanding the period to close on the replacement property.

In the scenario above, if the investor extends the filing, they will have until May 31, 2023, to close on the property.

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Preparing for a 1031 Exchange

Those currently in or soon to be entering into a 1031 exchange in 2022 can act now to prepare for the upcoming deadline. It is advised they speak with a 1031 Exchange specialist to learn more about exchange opportunities and speak with a certified public accountant (CPA) to further discuss exchange rules, including Section 1031 (a)(a)(B), and how they can extend their 2022 tax filing.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

·      There’s no guarantee any strategy will be successful or achieve investment objectives;

·      All real estate investments have the potential to lose value during the life of the investments;

·      The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;

·      All financed real estate investments have potential for foreclosure;

·      These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

·      If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

·      Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Factors to Consider When Investing in Multifamily Properties

Investing in real estate areas like multifamily properties has historically been attractive to investors because of its historical relative stability to other asset classes and its potential for higher returns. Other asset classes like office, retail, and hospitality experienced significant problems during the pandemic; for instance, national office vacancy rates in Q2 2021 reached an overall average of 15.6% according to a 2021 Q1 Commercial Edge Report.

In contrast, US Multifamily properties had an average vacancy rate of 4.2%, according to the CBRE US Multifamily report Q1 2021. In a period of employment uncertainty and substantial economic changes, those figures support multifamily as a bastion of potential security.

Outlined below are primary factors analyzed when investing in a multifamily asset. Our investment team at Perch Wealth takes pride in thoroughly underwriting and evaluating potential investments, including Delaware Statutory Trust (DST) multifamily offerings; here is a peak into our assessment process.

Establish “As Is” Value & Going in “Cap Rate”

First and foremost, when looking at a new deal, we determine the “in-place cashflow” of the asset. The rent roll must be analyzed to determine the current in-place rents, occupancy, market rent, and concessions. Next we compare those numbers with the profit & loss statement to determine the in-place Net Operating Income (NOI) of the asset.

As analysts, we normally anticipate changes to the expenses when the asset is acquired, such as an increase to real estate taxes, payroll, insurance, or property management fees. Understanding how cashflows will adjust upon changes in ownership is key to establishing what the Month-1 income will likely be to then determine our going in “cap rate”. Once the adjusted NOI has been calculated, we can determine our expense-adjusted going in “cap rate” by dividing the adjusted NOI by our projected purchase price.

The going in “cap rate” is more important for core/core-plus asset classes where there is less opportunity to immediately increase NOI through adding value to the property. On value-add properties the “Stabilized Return on Cost” is a more important metric to determine, which is the stabilized NOI divided by the total basis in the property.

Going in “cap rates” will vary depending on the quality of the market and asset, where each property must be compared to other sales comparable “cap rates” to help affirm that the investor is making a good purchase.

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Analyze Potential Value and Business Plan

Once the “as-is value” of a property has been determined, the potential of the property must be determined along with a business plan. For example, an older 80's vintage property that has not been upgraded, located near similar properties nearby that have undertaken renovations, would be attractive. If the comps are providing a premium in rents, there is an opportunity to potentially improve the property and charge higher rent, which in turn could increase our NOI and value of the asset.

When drafting the value-add business plan, an investor should consider how much they will spend to charge rental premiums for an improved rental product. The key metric to value this work is called “Return on Improvement Cost”. “Return on Improvement Cost” is calculated by taking the average post-improvement rent increase per unit annualized and dividing it by total improvement cost per unit.

For example, on a recent underwriting transaction by one of our analysts where the proposed spending was $16,358/unit in capital improvements to improve the interior units and common areas of a property, the business plan projected increasing rents $331 per month which equated to $3,729 of additional income per year. $3,729 divided by $16,358 equals a “Return on Improvement Cost” of 22.80%, which is a strong number that helped confirm the value of improving a property.

A good “Return on Improvement Cost” is generally around 18%-20%+, whereas lower numbers than that might not justify taking the time and effort to complete the job and risking additional capital on construction risk.

Savvy investors might also increase the NOI of a deal by improving the operations of a property. One might increase income by charging additional fees for things like pet yards, valet trash services, covered parking, amenity fees, or even laundry services. These help potentially increase top line revenue which in turn could increase NOI.

Expenses can also be optimized by reducing unnecessary services to the property, renegotiating landscaping contracts, installing low use water appliances which decreases water bills, installing LED lighting which decreases electricity bills, reducing payroll if possible, and in some markets, real estate bills can sometimes be challenged in court or with the county and reduced.

Small operating changes made to proper underwriting have the potential to add up and significantly increase returns through the hold period. An investor who digs in and makes the small improvements to operational underwriting could unlock hidden value in the property, afford to pay a higher price, and win bidding processes more often than groups who solely look at the historical operations of an asset.

Conduct Thorough Due Diligence and Capitalize for Deferred Maintenance

Whenever looking at a potential acquisition, it is important to conduct due diligence on the age and quality of the asset and the amount of capital that needs to be budgeted to anticipate repairing deferred maintenance during the hold period.

Primary considerations on a multifamily property deal include the age and quality of the roofs, the existence of poly piping, the existence of aluminum wiring, the age and condition of any elevators, condition of the parking lots, structural quality, age and condition of heating and cooling systems, and many other items. Prospective investors should adequately budget for anticipated capital improvements to the property which will affect how much they can afford to pay when they buy the property.

Choosing the Proper Financing

Different properties will require different types of debt financing to achieve the stated goals of the investment. If an investor anticipates a large capital budget and major revitalization project, they will probably have a tough time securing typical agency financing.

Typically, the best option would be a bridge execution provided by a debt fund. The benefits of going with bridge debt is the potential opportunity to increase leverage over the typical 75% LTV limits, floating rate debt, non-recourse money, and the ability to sell the asset within 3-5 years without a major pre-payment penalty.

Bridge lenders often allow high leverage/additional risk because they concur with the investor’s business plan and see the potential of the property to produce more income. The downside of going with these sort of lenders is that they are commonly more expensive; they will charge higher up front and back-end fees along with a higher interest rate to compensate for the additional risk.

When buying a stabilized core/core+ deal with a longer hold period than 3-5 years, it is generally a good idea to utilize an agency fixed rate deal because of the lower up-front costs and lower interest rates. The common downside to fixed rate agency financing is the lack of flexibility, as well as pre-payment penalties which can be financially burdensome.

If asset prices skyrocket 4 years into the 10-year agency debt term, the pre-payment penalty could be so significantly expensive that it does not make sense to sell, and the opportunity to take advantage of a heated sales environment is lost.

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Hold Period, Exit Strategy, and Returns

The duration of the investment must also be considered when evaluating a potential multifamily properties investment. An investor must ask themselves what metrics are most important to them such as capital preservation, long term cashflow, high IRR, etc. If an investor cares about capital preservation, they would most likely purchase a Class-A stabilized asset with little deferred maintenance, put low leverage on the deal and underwrite a hold period of 10 years.

An investor who favors higher returns could buy a value-add property in a less desirable location, initially place bridge debt financing on the deal, seek to improve the property and increase NOI, and then attempt to refinance the property if it successfully stabilizes in year 3 or 4 and hold the deal 10 years in total for their underwriting purposes.

An investor who prefers a high IRR will search for properties with potentially unlocked value, place short term bridge debt, strive to expedite their business plan, and usually attempt to exit within 3-5 years.

When valuing assets on the front end, investors must always consider who is likely going to buy the property from them and why. Over-improving a property can sometimes be counter-productive. If an investor renovates 100% of an older property, their pool of potential buyers just became a lot smaller because “value add groups” will no longer look at it since there is no “meat left on the bone”.

Likewise, more conservative Class A buyers would likely not be interested, even though the property is now in good condition, because the vintage is just too old for them to stomach. An ideal exit strategy is to leave some potential upside on the asset which can cause future bidders to overpay you for the unrealized value.

The returns of a property should be differentiated by its class, location, and business plan risk. There are no hard and fast rules for these returns and these numbers are constantly changing as real estate cap rates have declined in the past 10 years and recently consolidated even further.

It seems that high level multifamily real estate deal returns should be broken into four categories, including core, core plus, value add, and development. Core deals should command 10-12% IRRs, core plus 13-15%, value add 17-19%, and development deals should underwrite to at least a 22% plus IRR.

Underwriting returns include relying on current data, operational expertise, opinion, and sometimes educated guessing. At Perch Wealth, our job is to analyze hundreds of deals per year, compare the different opportunities and choose what we believe to be the best risk-adjusted deals for our clients’ needs.

Contact Perch Wealth to find out how we might be able to help you assess and decide upon the 1031 exchange solution that we believe makes the most sense for you.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

• There is no guarantee that any strategy will be successful or achieve investment objectives;

• Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;

• Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;

• Potential for foreclosure – All financed real estate investments have potential for foreclosure;

• Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.

• Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;

•Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

Tax Benefits of a 1031 Exchange for Real Estate Investors?

1031 exchanges, also known as Starker or like-kind exchanges, are a powerful tax-saving strategy for real estate investors. They allow investors to defer taxes on the sale of a property by using the proceeds to purchase a similar "like-kind" property. This means that instead of paying taxes on the sale of a property, the investor can put that money towards purchasing a new property, thus deferring the taxes. This can be a game changer for real estate investors looking to maximize their returns and minimize their tax burden.

In this blog post, we'll explore the tax benefits of 1031 exchanges for real estate investors. We'll start by explaining how 1031 exchanges work, and how they differ from traditional real estate sales. We'll then delve into the benefits of 1031 exchanges, including how they can defer taxes, how they can be used to diversify investment portfolios and how they can be beneficial for long-term wealth creation.

We'll also discuss the potential implications of the Tax Cuts and Jobs Act of 2017 on 1031 exchanges. By the end of this post, readers will have a solid understanding of how to use 1031 exchanges to defer taxes and maximize profits on their real estate investments. It's important to note that 1031 exchanges come with rules and regulations and it's always recommended to consult with a tax professional to ensure compliance and maximize the benefits.

Deferring Taxes

One of the most significant benefits of 1031 exchanges for real estate investors is the ability to defer paying taxes on the sale of a property. When an investor sells a property and uses the proceeds to purchase a similar "like-kind" property through a 1031 exchange, they can defer paying taxes on the sale until they sell the replacement property. This can significantly increase the investor's cash flow and overall returns.

To understand how this works, let's take an example of an investor who sells a rental property for $500,000 and is faced with paying a capital gains tax of $75,000. Instead of paying the taxes, the investor decides to use the proceeds from the sale to purchase a new rental property worth $500,000 through a 1031 exchange.

In this scenario, the investor has deferred paying the $75,000 in capital gains taxes until they decide to sell the new property in the future. By deferring the taxes, the investor is able to keep more of the money from the sale and use it to purchase the new property, thus increasing their cash flow and potential returns.

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It's also important to note that 1031 exchanges can benefit both commercial and residential properties, and it's not limited to one type of property, this makes it more versatile and useful for different types of real estate investors. Additionally, 1031 exchanges can be used in a series of transactions, allowing the investor to continue deferring taxes and compounding the benefits over time.

When compared to traditional real estate sales, 1031 exchanges can provide significant tax savings for investors. In traditional sales, investors must pay taxes on the sale of the property at the time of the sale, which can significantly reduce the amount of money available for reinvestment. With a 1031 exchange, investors can defer taxes and keep more of the money from the sale for reinvestment, potentially leading to higher returns over time.

It's important to note that the Tax Cuts and Jobs Act of 2017 has placed some limitations on 1031 exchanges, such as limiting the deferral of taxes to real property, not personal property and reducing the maximum exchange period from 180 days to 120 days. Investors should consult with a tax professional to ensure compliance with the new laws and to maximize the benefits of a 1031 exchange.

Diversifying Investment Portfolio

Another key benefit of 1031 exchanges for real estate investors is the ability to diversify their investment portfolios. By using the proceeds from the sale of a property to purchase multiple properties or different types of properties, such as multifamily or commercial, investors can spread out their risk and increase their potential returns.

For example, an investor who owns several single-family rental properties in one area may be at risk if the local economy were to suffer.

By using a 1031 exchange to sell those properties and purchase a multifamily property in a different area, the investor can diversify their portfolio and spread out their risk. Additionally, by diversifying into different types of properties, such as commercial properties, investors can take advantage of different cash flow and appreciation potentials.

In comparison to traditional real estate investing methods, 1031 exchanges can provide an efficient and tax-advantaged way to diversify investment portfolios. Traditional methods of diversification, such as buying multiple properties or different types of properties, often require paying taxes on the sale of each property, which can eat into profits. With a 1031 exchange, investors can defer taxes and use the proceeds from the sale of a property to purchase multiple properties or different types of properties without incurring significant tax liabilities.

It's important to note that investors must identify and acquire replacement properties within the 45-day identification period and 180-day exchange period in order to properly execute a 1031 exchange. Additionally, there are some restrictions on the type of transactions that qualify for a 1031 exchange such as related party transactions or cash boot. Investors should consult with a tax professional to ensure compliance with these rules and regulations, and to develop a strategy for diversifying their portfolios through 1031 exchanges.

In summary, 1031 exchanges can provide real estate investors with a powerful tool for diversifying their investment portfolios and reducing their tax liabilities. By using the proceeds from the sale of a property to purchase multiple properties or different types of properties, investors can spread out their risk and increase their potential returns.

Additionally, 1031 exchanges can provide a more efficient and tax-advantaged way to diversify compared to traditional methods. However, it's important to understand the rules and regulations, and to consult with a tax professional to ensure compliance and maximize the benefits.

Long-term Benefits

1031 exchanges can also provide long-term benefits for real estate investors. One of the most significant long-term benefits is the compounding effect of tax savings over time. When an investor defers taxes through a 1031 exchange, they can continue to defer taxes on each subsequent exchange, thus compounding the benefits over time. This can lead to significant tax savings for investors who engage in multiple exchanges over the course of their careers.

Another long-term benefit of 1031 exchanges is the potential for wealth creation. By deferring taxes and reinvesting the proceeds from the sale of a property, investors can potentially increase their returns and build wealth over time. Additionally, 1031 exchanges can provide investors with the flexibility to acquire new properties, to use leverage to purchase properties, which can increase the potential for profit, and to defer taxes on property appreciation.

When compared to traditional real estate investing methods, 1031 exchanges can provide long-term benefits that are not available through other methods. Traditional methods of investing, such as buying and holding properties, do not provide the same tax savings and wealth-building potential as 1031 exchanges.

It's important to keep in mind that 1031 exchanges come with rules and regulations that must be followed, such as the 45-day identification period and 180-day exchange period. Additionally, the Tax Cuts and Jobs Act of 2017 placed some limits on 1031 exchanges, and investors should consult with a tax professional to ensure compliance and maximize the benefits of a 1031 exchange.

In summary, 1031 exchanges can provide real estate investors with long-term benefits such as the compounding effect of tax savings over time and the potential for wealth creation. By deferring taxes and reinvesting the proceeds from the sale of a property, investors can potentially increase their returns and build wealth over time.

Additionally, 1031 exchanges can provide investors with the flexibility to acquire new properties, to use leverage to purchase properties, and to defer taxes on property appreciation. However, it's important to understand the rules and regulations and to consult with a tax professional to ensure compliance and maximize the benefits.

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Special Considerations for Commercial Properties

While 1031 exchanges can provide benefits for both commercial and residential properties, there are some special considerations for commercial properties that investors should be aware of.

One consideration is that commercial properties often have higher values and more complex ownership structures, which can make it more challenging to find suitable replacement properties within the 45-day identification period and 180-day exchange period. It's important for investors to work with a qualified intermediary who has experience with commercial properties to ensure compliance with these rules.

Another consideration is that commercial properties often have more restrictive zoning laws and regulations, which can limit the types of properties that can be used as replacement properties. Investors should be aware of these restrictions and work with a knowledgeable real estate professional to identify suitable replacement properties.

Additionally, commercial properties often require more due diligence and research, such as environmental assessments and property condition reports, which can add complexity and cost to the exchange process.

Finally, it's important to note that the Tax Cuts and Jobs Act of 2017 has placed some limitations on 1031 exchanges for commercial properties, such as limiting the deferral of taxes to real property, not personal property and reducing the maximum exchange period from 180 days to 120 days. Investors should consult with a tax professional to ensure compliance with the new laws and to maximize the benefits of a 1031 exchange.

In summary, while 1031 exchanges can provide benefits for both commercial and residential properties, there are some special considerations for commercial properties that investors should be aware of. These include the need to work with a qualified intermediary who has experience with commercial properties, the need to research and be aware of zoning laws and regulations, the added complexity and cost of due diligence, and the new limitations imposed by the Tax Cuts and Jobs Act of 2017.

It's important for investors to consult with a tax professional and knowledgeable real estate professional to ensure compliance and maximize the benefits of a 1031 exchange for commercial properties.

A QI's Contribution to a 1031 Exchange

For all 1031 trades, a qualified intermediary (QI) is necessary. Real estate investors must choose a QI they can rely on and trust given the significance of the QI in an exchange. However, doing so can be challenging because how can an investor tell whether a specific QI is credible? This quick guide will show you how to choose a trustworthy QI for a 1031 exchange.

A QI is what?

An individual or organization that facilitates a 1031, or like-kind, exchange in accordance with Internal Revenue Code (IRC) Section 1031 is referred to as a QI, sometimes known as an accommodator. According to the Federal Code, a QI's responsibilities are as follows:

A qualified intermediary is a person who: (A) Is not the taxpayer or a disqualified person; and (B) Enters into a written agreement with the taxpayer (the "exchange agreement") and, in accordance with the exchange agreement, obtains the property being exchanged from the taxpayer, transfers the property being exchanged, acquires the replacement property, and transfers the replacement property to the taxpayer. (26 CFR § 1.1031(k)-1)

A person can become a QI without having to fulfill any eligibility requirements or obtain a license or certificate. The Internal Revenue Service (IRS) does, however, specify that anyone who is related to the exchanger or who has had a financial relationship with the exchanger - such as an employee, an attorney, an accountant, an investment banker or broker, or a real estate agent or broker - within the two years prior to the sale of the relinquished property is disqualified from serving as the exchanger's QI.

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Why is a QI crucial to a 1031 Exchange?

Every 1031 exchanger is required to choose a QI and sign a formal agreement before closing on the property being given up. After being chosen, the QI's three main duties are to create the exchange documentation, swap the properties, and keep and disburse the exchange monies.

The Creation of Exchange Documents

The QI creates and maintains all pertinent paperwork throughout the exchange, including escrow instructions for all parties involved.

Trade of Properties

In a 1031 exchange, the QI is required to buy the exchanger's property that is being given up, give it to the buyer, buy the seller's property that is being replaced, and give it to the exchanger. Despite the fact that the QI also transfers the title, the QI is not technically required to be a link in the chain.

Exchange funds holding and releasingFor an exchanger to defer capital gains, all proceeds from the sale of the relinquished property must be held with the QI; any proceeds held by the exchanger are taxable. As a result, the QI must handle the sale funds of the property that was given up and put them in a different account where they will be kept until the replacement property is bought.

For the exchange to be valid, the exchangers must adhere to two crucial timeframes. At the conclusion of the identification phase, the first occurs. The exchanger is required to choose the new property to buy within 45 days after the transfer of the property being given up. At the conclusion of the exchange period, the second occurs. Within 180 calendar days of the transfer of the relinquished property, the exchanger must receive the replacement property. Even if the 45th or 180th day falls on a Saturday, Sunday, or legal holiday, these severe deadlines cannot be extended.

What factors should investors think about while selecting a QI?

Since a QI is not needed to hold a license, investors should do their research to make sure they choose someone who can manage the 1031 exchange effectively. Investors may be compelled to pay taxes on the exchange as a result of errors made by a QI because the IRS regrettably does not pardon any mistakes made by a QI. Here are some factors that investors should take into account while choosing a QI.

Statutes of the State

Although QIs are not governed by federal law, certain states have passed legislation that does. For instance, rules governing the sector have been passed in California, Colorado, Connecticut, Idaho, Maine, Nevada, Oregon, Virginia, and Washington. These states frequently have license and registration requirements as well as requirements for separate escrow accounts, fidelity or surety bond amounts, and error-and-omission insurance policy amounts.

Federated Exchange Facilitators

A national trade organization called the Federation of Exchange Accommodators (FEA) represents experts who carry out like-kind exchanges in accordance with IRC Section 1031. Support, preservation, and advancement of 1031 exchanges and the QI sector are the goals of the FEA. Members of the association must follow by the FEA's Code of Ethics and Conduct.

Additionally, the FEA has a program that awards the title of Certified Exchange Specialist® (CES) to those who meet certain requirements for work experience and who successfully complete an exam on 1031 exchange rules and processes. This certificate's holders are required to pass the CES exam and complete ongoing education requirements. To taxpayers thinking about a 1031 exchange, the designation "demonstrates that the professional they have selected possesses a certain level of experience and competence."

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Information and expertise

As previously stated, a QI error in a 1031 exchange could lead to a taxable transaction. Before making a selection, investors who are choosing an accommodator should carefully consider each person's credentials, including their knowledge and experience in the sector. Investors should find out if the person is employed full-time or part-time, and how many transactions and how much value the person has enabled. Furthermore, it's critical to understand whether the person has ever had a failed transaction and, if so, why.

Understanding 1031 exchanges is essential. Potential QIs should be familiar with the fundamentals as well as the specifics of the 1031 exchange procedure. For instance, QIs should be aware of what constitutes a like-kind attribute. They should also be aware of Delaware Statutory Trusts (DSTs), one of the most frequently disregarded alternatives to 1031 exchanges. Sadly, a lot of QIs are unfamiliar with DSTs. Investors who wish to successfully delay capital gains while still achieving their overall financial goals must find a qualified and professional QI.

How exactly should an investor choose a QI?

Investors should ask for recommendations to identify a QI in good standing. Finding a trustworthy QI might be a lot easier by word of mouth. Investors can request a recommendation from a real estate lawyer, a trustworthy title business, a certified public accountant (CPA) with experience in 1031 exchanges, or even the other party to the exchange.

Investors must probe potential QIs with inquiries that go beyond the bare minimum to learn more about their breadth of expertise and experience. For instance, the FAE mandates that prospective QIs work full-time for a minimum of three years before being allowed to take the CES exam. When evaluating a QI's experience, three years is a decent place to start; five to ten years is a good number.

One of the most important steps in a 1031 exchange is locating a qualified intermediary (QI), as the exchange cannot take place without one. Investors must confirm that their QI is knowledgeable about the numerous tax rules involved and has extensive experience. Additionally, investors must confirm that the QI is not a relative, an employee, or an agency and has had no recent financial ties to them. The IRS does not take these issues lightly; if the requirements outlined below are not met, there may be severe penalties assessed, or the IRS may even forbid the transaction from taking place at all.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

Are There New Rules for 1031 Exchanges in 2022?

Every year, concerns about the future of 1031 exchanges surface among investors. The ability to defer capital gains through a 1031 exchange has long been a point of contention among politicians. For those wondering whether changes to this real estate investing tool have been made recently, the answer is no. Rather, interest in 1031 exchanges has grown among investors throughout the country, and new questions have emerged. Here is a glimpse at the most common questions asked by today’s curious investors.

What happens when a 1031 exchange property is sold?

A 1031 exchange allows investors to trade one investment property (“relinquished property”) for another (“replacement property”) and defer capital gains taxes they would otherwise pay at the time of sale of the relinquished property. According to the Internal Revenue Service (IRS), the two properties must be “like-kind,” which under Section 1031 of the Internal Revenue Code is defined as any property held for investment, trade, or business purposes.

What are unrealized capital gains?

When investors and real estate professionals discuss unrealized capital gains, they refer to the gains made on an asset that has not yet been sold. If capital gains are unrealized, they are not taxed. Instead, these gains exist only on paper. Only when an investor disposes of the asset must taxes on capital gains be paid. 

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When can an investor use a 1031 exchange in real estate?

A 1031 exchange can be used anytime properties are exchanged as long as the properties meet the IRS’s definition of like-kind. Properties commonly traded in a 1031 exchange include commercial assets, such as apartment buildings, hotels and motels, retail assets and single-tenant retail properties, offices and industrial complexes, senior housing, farms and ranches, and vacant land. Additional trades that qualify as like-kind include investments in Delaware Statutory Trusts (DSTs) and residential properties held for investment purposes.

Can an investor avoid capital gains by buying another house?

Property owners commonly ask if they can sell their home and buy another house using a 1031 exchange. Unfortunately, the answer is no. Per the IRS, primary residences and vacation homes do not qualify for a 1031 exchange; only residential properties held for investment purposes for at least 12 months qualify.

Can an investor take cash out of a 1031 exchange?

For capital gains to be deferred, the total value of the relinquished property must be replaced, including both an investor’s equity and debt in the property. Therefore, if an investor sells a $1 million asset and has 50% leveraged, the investor will need to purchase a replacement property for $1 million and either leverage a loan for the $500,000 or pull from personal capital. Any cash taken out from the transaction is taxable.

Exceptions to the rule, however, do exist. One exception involves investing in a DST. A Delaware Statutory Trust is a legally recognized real estate investment trust that allows investors to purchase fractional ownership interest. When exchanging into a DST, investors can determine how much they want to invest and how much debt they want the DST sponsor to assign to them. A property owner could take out cash via a sale through this investment.

How does a 1031 exchange work?

A 1031 exchange requires investors to follow a strict timeline outlined by the IRS. Missing a deadline in the 1031 process generally results in taxes due on the relinquished property.

The timeline for a 1031 exchange starts when the relinquished property closes. The property owner has 45 days to identify their replacement properties and 180 days to close. The replacement properties must meet one of three rules defined by the IRS.

Do I need an intermediary for a Section 1031 exchange?

Yes! The IRS requires that 1031 exchanges use a qualified intermediary (QI) or exchange facilitator. After the sale of the relinquished property, all proceeds are held with the QI, who will release the funds for the acquisition of the replacement properties. If funds are held with the seller or any other party that does not qualify as a QI, the sale will not qualify for a 1031 exchange, and the seller will be responsible for paying capital gains.

How does a 1031 exchange work in a seller financing situation?

While seller financing is permitted in a 1031 exchange, it is not commonly used.

Seller financing reduces the immediate capital available for an exchanger; however, this does not exempt them from IRC section 1031 that states an investor must replace the entire value of the relinquished property. Therefore, an investor must identify how they will purchase their replacement properties when offering seller-financing. The most obvious solution is to offer short-term financing. This, however, does not solve most buyers’ problems. Instead, the exchanger can work with a qualified intermediary (QI) to sell the promissory note received from the buyer to cover the funds for the exchange. The exchanger can purchase the note or sell the note to the lender or a third party. Whatever option is used, all funds need to be with the QI by the end of the 180 days to prevent the proceeds from becoming taxable. Once proceeds are available, the investor can trade into a chosen like-kind property.

Can an investor still file a 1031 exchange after closing on a property?

No, a seller cannot file a 1031 exchange after closing a property because all proceeds from the sale must be placed with a QI. Therefore, if the exchange is not preplanned, the proceeds cannot be distributed appropriately for a 1031 exchange. Investors interested in a 1031 exchange should identify a QI before selling their real estate.

Can investors avoid capital gains tax if they reinvest?

A 1031 exchange allows property owners to defer capital gains when they reinvest and follow the rules outlined by the IRS. Reinvestment gives investors access to the numerous benefits offered by a 1031 exchange, including portfolio diversification and deferment of capital gains. Additionally, reinvestment via a 1031 exchange resets the depreciation schedule on the investment, providing investors access to additional tax advantages.

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What are the hottest markets for real estate investing in 2022?

The hottest market for real estate investing depends on an investor’s investment strategy. Is the investor risk-averse and looking for only stabilized assets in primary markets? Or are they willing to take on some risk for higher returns and invest in a value-add asset or a secondary or tertiary market?

To best understand which asset and market are best for you, contact a qualified 1031 exchange specialist. The team at Perch Wealth can guide you through the process and introduce you to 1031 qualified properties that are in line with your financial and investment objectives.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure: