1031 Exchanges - Market Adaptation and Equity Reinvestment
This article provides a high level overview of how IRS code 1031 (commonly known as 1031 exchange) enables you to reinvest equity and adapt to changing markets with no tax consequences.
Market Adaptation and Equity Reinvestment
Even though most real estate markets are very stable, over time they do change and you need to be able to adapt. Also, by definition, return on equity is zero so most investors will want to reinvest the accumulated equity in order to increase returns. 1031 exchange is the answer to both situations. And, if you conform to 1031 exchange rules, there are no tax consequences.
1031 Exchange Concept
Simplistically, if an income producing property is sold and the proceeds of the sale are reinvested in one or more income producing properties then no gain or loss is recognized. (Don't you wish you could do this with stocks!) The image below illustrates this progression many investors follow using 1031 exchanges.
You can even exchange single-family homes for mineral rights, condos or commercial properties. With a "NNN" (triple net) lease the tenant pays all real estate taxes, building insurance, management and maintenance and you receive a fixed monthly payment, usually with inflation escalators. Triple net leases are totally passive; you have no involvement in the operation of the building. Also, at the end of the lease the property comes back to you. Who offers such leases: food chains (McDonalds, Starbucks), the government (Post Offices), and many other major companies who need buildings but do not want to tie their capital up by purchasing property.
All 1031 exchanges revolve around two absolute deadlines. Within 45 days of closing on the relinquished property, you must file a list of possible replacement properties with an intermediary, which is a firm certified to act as a qualified intermediary. The second deadline occurs 180 days after the initial transaction. At that time, the exchanger must close on a replacement property, using equity equal to or more than the equity in the original property.
In the 1031 exchanges we have handled, the entire exchange event usually took less than 45 days; none exceeded 60 days. The cost of the qualified intermediary was less than $500 per property and they were well worth their fees. Below is a diagram showing the basic exchange process.
In this article we provided a high level overview of the 1031 exchange process and how it enables equity reinvestment and market adaptation with no tax consequences.