While a 1031 Exchange can carry substantial benefits, there are certain requirements that must be taken into account, as improper execution could cause an investor to miss out on the tax advantages of the exchange.
A 1031 Exchange is a way for commercial real estate investors to defer capital gains taxes after selling a property. While a 1031 Exchange can be an effective investment technique, there are certain requirements and strict time deadlines that need to be met. In some situations, using a bridge loan in conjunction with a 1031 Exchange can help quickly facilitate the transaction.
Tax Benefits of a 1031 Exchange
The major purpose of a 1031 Exchange is to realize tax benefits by reducing or deferring upfront capital gains taxes on the sale of real estate. These tax benefits are achieved by investing in a replacement property that is of a similar category or type as the property being sold.
This action constitutes the exchange portion of the 1031 transaction since the business owner investor essentially swaps the property to be sold for a new, replacement property. For long-term investors, a 1031 Exchange affords the ability to continually trade up by exchanging higher value properties without having to incur capital gains tax.
1031 Exchange Requirements
While a 1031 Exchange can carry substantial benefits, there are certain requirements that must be taken into account, as improper execution could cause an investor to miss out on the tax advantages of the exchange. These include:
Capital gains tax – A property seller undertaking a 1031 Exchange is liable to pay capital gains tax on the difference in value between the sale property and the replacement property. If there is a difference in the mortgages, this can reduce the expected tax benefit.
Third-party facilitation – Investors interested in a 1031 Exchange must use an external third party to facilitate the exchange. Reliance on another party incurs higher fees and more processing time.
Like kind requirement – This requirement means that a property asset that is sold must be exchanged for a similar type of asset. Properties do not have to be the same value or condition, but for instance a property owned in the United States could not be exchanged for an international property.
Timelines to Complete a 1031 Exchange
The IRS defines the specific limits on the timeline for completing a 1031 Exchange. There are two important dates that must be met to qualify for 1031 tax benefits. Both dates are triggered after the official transfer of ownership of the property being sold.
Fixed timeline – There is a fixed amount of time to complete the transaction. If the investor fails to meet any of these deadlines, they will lose tax exemption eligibility.
Identification of replacement property – There is a 45-day window after the sale to identify a replacement property. During this identification period, the investor can typically select up to three potential replacement properties.
Completion of sale – There is a 180-day window after the sale to close on the new property. All paperwork and inspections must be completed within this six-month time frame. Investors who meet both criteria will then be able to realize the capital gains tax advantage.
Using a Bridge Loan to Meet a 1031 Exchange Deadline
In some cases, real estate investors in the process of a 1031 Exchange will try to fund the difference in price between the exchanged and designated properties. When this scenario is not feasible, either because of time or overall liquidity, investors should consider a bridge loan to smooth the completion of the Exchange.
For instance, if one of the identified properties has a higher selling point than the property being exchanged, an investor might lack sufficient funds to complete the transaction. Obtaining bridge loan financing provides the flexibility to complete the transaction within the constraints of the Exchange timeline.
To learn more about how a short-term bridge loan can pair with a 1031 Exchange to facilitate a real estate transaction, get in touch with the experienced lending team at Wilshire Quinn Capital. They are able to fund 1031 Exchange loans in as little as 5 days and have the expertise to meet strict 1031 Exchange deadlines.
Since 2011, Wilshire Quinn Capital has served as manager of the Wilshire Quinn Income Fund, LLC, a direct portfolio lender that originates commercial bridge loans secured by real estate nationwide (CFL#603J060).
The information above is deemed reliable but is not guaranteed. Your decision to enter into a 1031 Exchange should be based on your own particular financial circumstances and investment objectives. Please consult your tax professional or financial advisor before entering into a 1031 Exchange.