Jim Christman, | Vice President & Trust Officer, Lake Charles, LA
Chris Holtzclaw, | Chief Fiduciary Officer, ATC-Western Region
Investing in real estate continues to be a popular wealth management strategy for Americans of a range of wealth levels. In fact, an estimated 60% of high net worth individuals are expected to increase their real estate investments this year, according to a survey by National Real Estate Investor.
The benefits of a real estate investment are clear — monthly income from rent payments and sometimes a significant capital gain when a property is eventually sold. But a successful real estate sale can also bring with it a significant tax burden.
Fortunately, savvy investors can take advantage of an underused tool, called a 1031 exchange, to defer capital gains taxes on their investment properties for years to come. Under the rules of a 1031 exchange, an investor can take the sales proceeds of a real estate investment and roll them directly into a new investment without having to pay taxes. Although there are several important guidelines that investors need to follow, using this strategy may result in huge tax savings that can last decades.
Named after Section 1031 of the IRS tax code, 1031 exchanges were originally established to spur investment in real estate and personal property. Some investors initially took advantage of exchanging personal and intangible property such as machinery, equipment, aircraft, artwork, collectibles, patents and other intellectual property. However, in 2017, the Tax Cuts and Jobs Act tightened the restrictions for 1031 exchanges, allowing them to be used for real estate investments only.
To utilize a 1031 exchange, the investor must work with a qualified intermediary — a third party that handles the transfer of funds from one investment to the next. The investor never receives back the initial investment or proceeds from the sale of the property. Instead, the qualified intermediary holds the money in an escrow-like account until it’s used to pay the seller of the replacement property.
At Argent, we’ve served as a qualified intermediary for many of our clients. Our services for real estate investors go far beyond that, though. We also coach our clients through the process and help them understand how a 1031 exchange works into their broader investment strategy, working as necessary with the client’s CPA or attorneys.
There are a few other important requirements for using a 1031 exchange, many involving the selection of the replacement property or properties. There are limitations on the types of properties that are eligible to be bought and sold using a 1031. For example, an investor can’t use their own residence or a vacation home that they use themselves. In addition, the replacement properties have to be located in the United States.
The investor has 45 days after selling their original property to identify any replacement properties, which they must do using one of three specific methods:
• Using the Three Property Method (the most common), the investor can name up to three potential replacement properties in which they want to invest.
• Using the 200% Rule, the investor identifies an unlimited number of potential replacement properties whose value adds up to no more than 200% of the value of the property they relinquished.
• Using the 95% Rule (the least common), the investor can identify an unlimited number of replacement properties, although they must purchase 95% of the total identified value.
The purchase of any replacement properties must be completed within 180 days after the sale of the relinquished property. In order to enjoy all the benefits of a 1031 exchange, the investor needs to roll their entire original investment and any sales proceeds into the replacement properties. Any proceeds not used will be taxed as capital gains.
Although 1031 exchanges might sound like a tax strategy aimed at the ultra wealthy, they can benefit ordinary investors by making it possible for them to replace real estate investments that aren’t suiting their needs. For example, a couple who owns raw land that’s not producing income could sell it and invest the sales proceeds into apartments (and generate income). Alternatively, an investor might want to sell their apartments because they no longer want to deal with the headaches of managing property. Raw land in the right area might be a wise buy-and-hold investment in hopes of a windfall down the line.
Regardless of your individual situation, if you own a real estate investment property, it’s worth inquiring whether a 1031 exchange is right for you. At Argent, we offer fiduciary-level investment management services that will help you make the best decisions for growing and protecting your wealth.
Contact us to learn more.
