Many of our Arizona real estate investors are asking us how to do a 1031 exchange in Arizona. Commonly referred to by the IRS as Section 1031, a Like-Kind exchange or a Starker exchange, a 1031 exchange is a very good strategy for tax deferment. A 1031 exchange is not restricted to only real estate but most of the instances we experience have to do with 1031 exchanges of real property.
With the recovery of Arizona real estate pricing as well as the current low levels of real property inventory, we are seeing a number of our investors thinking about exchanging out of their current real estate investment holdings. Investors may fare well by taking their gains now and reinvesting in other types of real estate investment. So back to the original question of how to do a 1031 exchange in 2017.
How To Do a 1031 Exchange
To preface, we must encourage all readers of this article to consult their CPAs and/or tax attorneys prior to acting on any of the information in this article. With that out of the way, let’s discuss the 1031 exchange in greater detail.
Basically, with a 1031 exchange, you’re exchanging one property for another property that is similar in class or that is a “like-kind” property. The term “like-kind” is a bit broad but if we are wanting to exchange out of real property, we will always exchange our current real property asset for another real property asset. Although the properties do not have to be of the same value, it typically behooves investors to exchange old property for new property that is at least the same value or just a bit more so as not to incur any tax liability on the exchange.
There are four types of exchanges that an investor can do under Section 1031 when considering how to do a 1031 exchange and they are as follows:
- Simultaneous Exchange: With the Simultaneous Exchange, the investor property being exchanged closes escrow on the same day as the new property being exchanged for. This type of 1031 exchange isn’t very common since it doesn’t offer near the flexibility for the investor should something not go as planned on one of the investment property closings. The Simultaneous Exchange was the original 1031 exchange; a direct exchange of like properties between two parties. But with the Delayed Exchange,
it really doesn’t make much sense to use the Simultaneous Exchange as a 1031 exchange option.
- Delayed Exchange: The Delayed Exchange is the most popular and it is just as commonly referred to as the 3 Property Rule. In this scenario, the investor will first sell the current investment property. Within 45 days of the close of escrow on this property, the investor must identify a replacement property or replacement properties
- Reverse Exchange: The Reverse Exchange seems much more simple but since this exchange involves the investor purchasing the replacement property before selling the property being exchanged, it is difficult to execute. This is because with a 1031 exchange, the replacement property and the relinquished property may not have the same owner on title at the same time. There are ways around this but many investors may deem the number of steps involved to get this exchange done, unnecessary.
- Construction or Improvement Exchange: Often during the process of a 1301 exchange, investors find a replacement property with very good upside but property that be valued less than the property to be relinquished. If this is the case and there are no other additional properties the investor would like to purchase, the investor stands to have tax liability after the 1031 exchange has been executed. The Construction or Improvement Exchange would be a 1031 exchange which would allow the investor to invest the remaining funds into the replacement property thereby eliminating most of or all of the tax burden that may exist.
At some point, an investor will sell out of the investment position all together and pay taxes due on any capital gain but until this time, an investor has the ability to trade in and out of investment properties without incurring immediate tax burdens, as long as the replacement properties have values that are equal to or greater than the values of the relinquished properties. The 1031 exchange is a valuable investment tool for investors of tangible property.
Please note however, the IRS 1031 Exchange rules do require that both the purchase price and any new loan amount be at least the same or higher on the replacement property than they would have been on the relinquished property. This means that an investor selling a $500,000 property in Scottsdale, Arizona that had a $250,000 loan, would have to purchase a replacement property priced at $500,000 or more and leverage at least $250,000 for the purchase.
This article is meant to give you the general idea of what the 1031 exchange is and the options an investor has when executing a 1031 exchange this year. As we noted near the beginning of this article, we encourage all investors to consult their CPAs and/or tax attorneys for all of the most current laws and requirements for the 1031 exchange. We hope this article has helped you understand how to do a 1031 exchange in 2017.
Here is a link to the IRS IRC Code Section 1031 governing like-kind exchanges and the associated tax deferment rules.
Should you be an investor and have interest in greater Phoenix Arizona investment property, please feel free to CONTACT our professional team of Phoenix Arizona real estate agents. We can help you with identifying your prospective replacement properties as well as the negotiation for the purchase(s).