What is a 1031 Exchange?
A 1031 exchange (IRS code Section 1031) is an exchange that occurs when one investment property is sold in order to purchase another. When swapping an investment property for another, there would typically be a significant amount of capital gain taxes. However, if this transaction qualifies as a 1031 exchange, these taxes may be deferred indefinitely. This allows investors the opportunity to move into a different class of real estate and/or shift their focus into a new area without getting hit with a large tax burden.
The 1031 exchange mechanism is used by some of the most successful real estate investors and can be beneficial in a variety of situations. Although most swaps aren’t completely immune to sales taxes, some qualify for no tax or limited tax due if they meet the 1031x requirements.
What Are The Requirements?
Owners of investment property may qualify for a Section 1031 deferral.
Most exchanges must be of “like-kind” which is really quite forgiving – the property you obtain doesn’t need to be exactly the same as the one that you relinquished. For example, a condominium may be exchanged for a ranch, as long as both are listed as investment properties and reside within the U.S.
For the purposes of residential lending, the property in question must be a business or investment property, which means that a personal residence won’t qualify for a 1031 exchange. However, a single-family rental property could be exchanged for commercial rental property.
The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind. If cash is received, relief from debt, or property that is not like-kind, however, this may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.
What Are The Benefits?
The most obvious benefit of a 1031 exchange is the tax relief. Moreover, the equity used to purchase investment property can continuously rollover to the next, and so on. This means that the investment can continue to grow tax-deferred until the owner decides to cash out and recognize a capital gain.
How Does This Impact My Ability To Qualify For a Residential Mortgage?
Typically, when a borrower is looking to utilize their 1031x funds for the purchase on another property, their mortgage financing will follow suit in the form on an investment property mortgage loan. Mortgage financing for investment properties feature slightly higher interest rates than that of a primary residence or a second home.
If you have any questions about 1031 exchange or mortgage loans, please don’t hesitate to contact us at (760) 930-0569 to discuss your options.