If you are a real estate investor in Los Angeles or interested in becoming one, you may have heard of the “1031 exchange”. Also known as a “like-kind” or Starker exchange, a 1031 Exchange is a strategy used by many successful investors to defer payment on capital gains. It’s widely used by real estate investors who take advantage of its tax-deferred benefit to grow its portfolio.
What is a 1031 Exchange?
A 1031 Exchange is a type of transaction that allows you to defer capital gains tax, depreciation recapture tax, and state income tax from the sale of a commercial or investment property by taking the proceeds from the sale and reinvesting them into a new property.
In order to qualify for a 1031 exchange, there are several requirements that must be met.
- All proceeds must be reinvested into a “like-kind” property. What constitutes as “like-kind” is widely encompassing, but it’s strictly limited to commercial or investment properties only. You cannot exchange a primary residence for a commercial property. It’s best to consult a 1031 Exchange expert to learn about the many “like-kind” opportunities you can explore.
- The price of the new property must be equal to or higher than the net sale of your current property. If you’re investing in a rental home, it helps to be aware of the average house price in Los Angeles
- A new property must be found within a 45-day period and its acquisition must be completed within 180 days after the sale of your property
Types of 1031 Exchange
There are 3 types of 1031 exchanges
- Deferred – Also called a delayed exchange, this is the most common type of 1031 exchange. After you close on your current property, you find a new one within a 45-day period and close within 180 days.
- Simultaneous – After closing on your current property, you close on a new one almost immediately.
- Reverse – You purchase a replacement property before closing on your current one.
How to perform a 1031 Exchange
- The first step of a 1031 exchange is to determine whether or not your property is a good candidate. For instance, if the property has losses that are equal to or greater than what you would make on it, it is not a good fit.
- After you list your property for sale, it is a good idea to begin looking for new properties if you have not found one already. You only have 45 days to find one after your property sells. You will then need to close the purchase within 180 days of the closing of your previous property. It is recommended that you work with a qualified professional, especially if you have never done a 1031 exchange before, to make sure the process goes smoothly and you don’t miss the tight deadlines.
- Keep in mind that you should reinvest all of your proceeds. If you take money out, which is referred to as a “boot,” you will be taxed on the money you keep. This sum is taxable up to the total realized gain of the exchange.
- In California, you must also be aware of the Clawback rule. This basically states that if you exchange a California property for an out-of-state asset, you will be liable to pay capital gains tax when you sell the asset in a non-1031 transaction. This means the property becomes taxable in both California and the state in which the property is located.
Benefits of a 1031 Exchange for investors
The biggest advantage of a 1031 exchange is its tax-deferred privilege. You also gain the following benefits:
- Ability to grow and diversify your portfolio while deferring taxes
- Greater purchasing power
- Management relief when you acquire a turnkey property or several turnkey properties
- Upgrading into a more profitable or desirable asset