What is a Qualified Like Kind Property in a 1031 Exchange?
What is a Qualified Like Kind Property in a 1031 Exchange?
Any investor who purchases commercial real estate abroad is interested in reliable tenants and long-term relationships with them. At the same time, an important parameter of the object is the type of existing lease agreement, which determines the number of expenses that fall on the shoulders of the tenant. Unlike gross lease (gross lease), when the lessor assumes most of the operating costs, the net lease is preferable for the investor. Let us dwell in more detail on this type of lease (net lease) and its varieties. Let’s take a closer look at the Triple net lease type.
Triple net lease
Triple net lease or triple net lease (NNN lease) – an agreement according to which all expenses for the maintenance of the object are under the control of the tenant. That is, he pays taxes, insurance, repairs and maintenance of the real estate.
Of course, the purchase of NNN lease real estate, which is already leased, gives the investor a number of advantages over the acquisition, for example, of a residential building.
Benefits
These benefits include:
long term relationship
The tenant has already made a choice in favor of a particular object and intends to use it for many years. The investor receives not only real estate but also established relationships with the tenant/tenants.
stable income with minimal worries
The investor knows in advance the level of profitability of the commercial objectives and the amount of regular financial receipts. At the same time, all unforeseen expenses, such as repairs or an increase in tax rates, fall on the shoulders of the tenant.
freedom of movement
It is not important for the owner of real estate to be in the same locality as the object – the tenant is responsible for its maintenance.
the possibility of attracting co-investors (co-tenancy)
Commercial property that already has a tenant(s) can be purchased by multiple investors at once.
Like Kind Property
When in a transaction with various kinds of real estate, there is a requirement of “homogeneity,” then it does not carry the meaning of sales and purchases of a single type of property. The term “like-kind” specifically means only the nature of the property, without regard to class or level of quality. As a result, absolutely any property is equivalent. In more detail, real estate of this kind is very common in the modern world.
What does it give? This allows people to look for replacements for their property without getting hung up on certain characteristics and features. To be honest, this does not always work in real life, but nevertheless, such a scheme has a place to be.
Exchange 1031 – main information
In real estate, a 1031 exchange is the exchange of one investment property for another, allowing you to defer capital gains taxes. The term, which takes its name from section 1031 of the IRS code, is used by realtors, title companies, investors, and football moms. Some people even insist on turning it into a verb, like “Give 1031 that building to another.”
IRS Section 1031 has many moving parts that real estate investors need to understand before attempting to use it. Exchanges can only be made with similar properties, and IRS rules limit the use of properties for vacation purposes. There are also tax implications and time frames that can be problematic. However, if you’re considering option 1031 or are just curious, here’s what you should know about the rules.
What is Article 1031?
In general terms, a 1031 swap (also called a like-for-like or Starker swap) is an exchange of one investment property for another. While most swaps are taxed as sales, if your swap qualifies for 1031, you will either have no tax or limited tax payable at the time of exchange.
In fact, you can change the form of your investment without (according to the IRS) cashing out or recognizing capital gains. This allows your investment to continue to grow before taxes. There are no limits on how many times or how often you can make 1031. from one investment property to another, to another, and another. Although you may profit from each swap, you avoid taxes until you sell for cash many years later. Then, if everything works out as planned, you will pay only one tax, and this tax is at the rate of long-term capital gains (currently 15% or 20%, depending on income – and 0% for some lower-income taxpayers).
Most exchanges should just be “similar” – a cryptic phrase that doesn’t mean what you think. You can trade an apartment building for damp land or a ranch for a mall. The rules are surprisingly liberal. You can even trade one business for another. But there are traps for the unwary.
Regulation 1031 applies to investment and business property, although the rules may apply to a former primary residence under certain conditions. There are also ways to use 1031 to trade vacation homes – more on that later – but that loophole is much narrower than it used to be.
Delayed exchanges and time rules
Typically, an exchange involves the simple exchange of one property for another between two people. But the chances of finding someone with exactly the property you want, who wants exactly what you have, are slim. For this reason, most exchanges are deferred, tripartite, or Starker exchanges (named after the first tax case in which they are allowed).
With a deferred exchange, you need a qualified intermediary (intermediary) who will hold the money after you “sell” your property and use it to “purchase” the replacement property for you. This three-way exchange is treated as a swap.
When postponing an exchange, you must follow two key timing rules:
45 day rule
The first relates to the designation of the replacement property. After the sale of your property, the intermediary will receive cash. You cannot receive cash. Otherwise, the treatment will be ruined 1031. In addition, within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary, indicating the property you wish to purchase. The IRS says you can nominate three properties if you end up losing one of them. You can even nominate more than three if they qualify for certain evaluation tests.
180 day rule
The second rule of time for a delayed exchange relates to closing. You must close the new property within 180 days of selling the old one.
Brief information
These two time periods run at the same time, which means that you start counting when the sale of your property closes. For example, if you schedule a property replacement in exactly 45 days, you only have 135 days to close it.
Tax Consequences: Cash and Debt
You may have cash left after the intermediary purchases the new property. In this case, the intermediary will pay you after 180 days. This cash, known as the “boot,” will be taxed as partial proceeds from the sale of your property, usually as a capital gain.
One of the main ways people get into trouble with these transactions is by ignoring loans. It would help if you accounted for mortgages or other debt on the property you are giving up, as well as any debt on the property you have replaced. If you do not receive cashback, but your obligations decrease, this will also be considered income for you, just like cash.
Let’s say you have a $1 million mortgage on your old property, but your mortgage on the new property you get in return is only $900,000. You have a $100,000 profit that is also classified as “profit” and will be taxed.
Exchange 1031 for holiday homes
You may have heard stories of taxpayers who used the 1031 clause to swap one vacation home for another, perhaps even for a home they wanted to retire in, and Section 1031 delayed income recognition. They later moved into a new property, made it their primary residence, and eventually planned to use the $500,000 capital gains exemption. The exception allows you to sell your primary residence and protect a $500,000 capital gain with your spouse if you have lived there for two of the last five years.
In 2004, Congress closed this loophole. Yes, taxpayers can still convert vacation homes into rental properties and make 1,031 exchanges. Example: You stop using your beach house, rent it out for six months or a year, and then exchange it for another property. If you have a tenant and are businesslike, you’ve probably turned the house into an investment property, which should make your 1031 exchange okay.
However, if you offer it for rent but never actually have tenants, this is probably not acceptable. Facts will be key, as well as time. The more time that passes after the conversion of the use of the property to a rental, the better. While there is no absolute standard, more than six months of fair use on a rental is probably needed. The year will be better.
Conclusion
Experienced real estate investors can use the 1031 exchange as a tax-deferred income-boosting strategy. Many complex moving parts require not only an understanding of the rules but also the involvement of professional help, even for experienced investors.
Related Articles:
Realized vs Recognized Gain in 1031 Exchange
What is a 1031 Exchange Drop and Swap?
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