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What is a 1031 Exchange ?

A 1031 Exchange is a beneficial tax loophole that’s widely used by real estate investors.  A 1031 Exchange will allow you to re-invest the full proceeds from the sale of your investment property to another like-kind investment and defer paying capital gains tax. It’s a simple enough concept to understand but it can be very complicated depending on how you use it.

So how does a 1031 Exchange work? Let’s say you own an investment property in the Heights of Jersey City and want to upgrade to a new condo being built in Downtown Jersey City.  You paid $500,000 for your current investment several years ago and recently sold it for $900,000 today.  Rather than paying capital gains tax on the $400,000 appreciated value,  a 1031 Exchange would allow you to reinvest the entire proceeds of your sale into your new investment.

There are three types of 1031 Exchanges: Deferred or Delayed 1031 Exchange, Simultaneous 1031 Exchange and a Reverse 1031 Exchange.

Deferred or Delayed 1031 Exchange

A Deferred 1031 Exchange allows for an investor to sell an investment property and identify a replacement property to which they will re-invest the full value of their sale. An investor will need to identify up to three properties as potential purchases within 45 days of the sale of their original investment and will need to close on one or more of them within 180 days in order for the exchange to be valid.  Amy Frank Goldman – President AFG Wealth Management in Hoboken suggests identifying a Delaware Statutory Trust (DST) as one of the three property options.  If you fail to close on either of your preferred investment properties, you will still be able to make use of the 1031 Exchange by investing in a portfolio of investment properties that a DST offers.

This type of exchange requires a qualified intermediary (typically your attorney) to handle these funds in an escrow account until the transaction has been completed.  Making use of these funds prior to the 180 days will nullify the 1031 exchange.

Simultaneous 1031 Exchange

The investor closes on both properties simultaneously or within a day of each other.  The investor may use a qualified intermediary but is not required to.

Reverse 1031 Exchange 

The investor buys the new property prior to the sale of their original investment

General rules to remember when using a 1031 exchange 

Investors should remember that the new investment property should be of equal or greater value then the investment that was just sold and that all proceeds from the sale will be used in the purchase of the new investment property.  In short, you’re not walking away with any cash in your pocket. Simply, a better investment.    

If the investor uses cash from the sale for capital upgrades (a “boot”) in the new investment property, the investor will be responsible for the taxes on that “boot” portion of the exchange.

A “mortgage boot” is when the investor reduces the mortgage liability on the new investment property below the mortgage liability of the recently sold property. The new investment property needs to carry a mortgage that is equal to or greater than the previous investment or incur taxes on that “boot” value.

So, why would an investor want to use a 1031 exchange? There can be many reasons but the most significant is to defer capital gains tax when trading up to a more valuable investment. An investor may want to sell their Hoboken investment and move to the booming downtown area of Jersey City or grab a multifamily investment in the Heights. Regardless of the reason we suggest you reach out to your tax or wealth advisor to discuss the transactions in greater detail.

If you have any questions or want to discuss strategies, do not hesitate to reach out to me.

Rich Cronin – (201) 566-6049

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One Response to “What is a 1031 Exchange ?”

  • It was helpful when you explained that the process of a DST 1031 exchange required the funds to be handled by a qualified intermediary. My husband and I were going over our finances over the weekend and agree it’d be smart to start investing in real estate properties this year. Thanks for helping me better understand what to expect if we choose to use a DST 1031 service!

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