There are a number of business or investment purposes a real estate owner might consider a Florida 1031 exchange, from swapping out a potentially bad property to saving on federal capital gains taxes. It can benefit you as a property investor as you exchange one investment property for another replacement property.
As a Florida real estate investor, you can make huge tax savings when looking to sell an investment property. Normally, when selling a business or an investment, the IRA expects you to pay up to 30 percent in capital gains taxes on the relinquished property.
Luckily for property owners, there is a legal way in which you can avoid this tax burden. And that is through the 1031 Exchange which is contained in Section 1031 of the IRA Code or Internal Revenue Code. This part of the Internal Revenue Code basically allows investors to exchange one property for another in order to defer taxes.
There is a catch, though; you must exchange a “like-kind” property during a Florida 1031 Exchange for the replacement property. In real estate law, this kind of property is a property that is similar in nature to another and is held in the United States. They also has to be business or investment properties, as opposed to personal properties.
Eligible 1031 Property Types
Below are examples of real property that are eligible for a 1031 consideration.
- Vacation rental property
- Water and ditch rights
- Oil, gas and mineral interests
- Self-storage facilities
- Trailer parks
- Golf courses and practice ranges
- Shopping malls and strip centers
- Businesses owning real property
Others are communication towers, timberland, rental properties, hotels and motels, apartments, gas stations, commercial buildings and warehouses, land, and convenience stores. Read our guide to finding the right Miami investment property here.
Properties that aren’t eligible for a 1031 exchange include inventory, partnership interests, indebtedness, primary residences, vacation property, and stocks, bonds or notes. Even a qualified intermediary cannot exchange these.
Types of 1031 Exchanges
There are two main 1031 exchange types. The first type is “Delayed Exchange”, also known as “Starker Exchange”, this is the most common exchange format. It allows investors a period of up to 180 days after the property sale to buy a replacement property to replace their relinquished property
This means that from the time you sell your Miami property until you close on the new one, you’ll have a maximum of six months to do it. A qualified intermediary is required during this process. Make sure you have up to three properties lined up for the potential exchange. Real estate transactions require a lot of planning beforehand.
Identify potential replacement properties for your 1031 Exchange beforehand and you should be able to close on one of these properties within the allotted 6-month period. Once you have gained and relinquished property, the 1031 exchange will be complete and the property intended for exchange will have a new owner.
The other type of 1031 exchange is called “Reverse Exchange”. "Reverse Exchange" is the opposite of a “Delayed Exchange”. This 1031 exchange occurs when an investor acquires a replacement property before they have finished transferring the relinquished property. You may even be eligible for a tax deferral on the new property.
Having property sold before acquiring a new property is required for a 1031 exchange. Exchanging raw land for fair market value isn't the best strategy for a 1031 exchange. A simultaneous exchange is possible but difficult to pull off as both properties involved would need to be thoroughly checked and agreed upon beforehand. A qualified intermediary would be needed for this process.
It is against the IRA Code to own both the replacement and relinquished properties at the same time. The only exception is when an investor has the financial means to make the new purchase.
An Exchange Accommodation Titleholder (EAT) is usually created to take title or park either the old or new property.
Requirements for a Florida 1031 Exchange
The first thing that is needed for a successful 1031 Exchange is “Qualifying Property.” Qualifying property is one that is in use either as a business or an investment. Your primary residence, for instance, doesn’t qualify for a 1031 exchange due to the status of the sold property.
The other requirement for a 1031 Exchange is that both properties (the ones being relinquished and the potential replacement properties) must be “like-kind”. Basically, like-kind properties are those that have the same nature, character, or class, though not always in purchase price.
Next in a Florida 1031 Exchange, the property being relinquished must be exchanged for a property that is of equal or greater value. If the replacement property is of less value, then some tax would be due to the IRA. You will need a qualified intermediary to follow through with this process for your commercial properties.
A 1031 Exchange also operates under defined time periods. Once you have closed a sale, you will have a maximum of 45 days to identify a replacement property. You may identify up to 3 “like-kind” properties for the 1031 exchange. Once you have identified one, you’ll have 6 months to close on the sale.
Another requirement is that the name on the title of the properties being relinquished and that on the replacement property must match those on the tax return forms. An exception to this is if you are using a single-member limited liability company.
What is meant by “Boot”?
Boot results when the proceeds of the 1031 exchange aren’t 100% invested in a replacement property. Suppose, for example, you have sold a property for $200,000. But for whatever reason, you only end up investing only $180,000 during the Florida 1031 Exchange. Now, the difference ($20,000) is what would be referred to as boot.
The goal of a 1031 exchange is to defer having to pay capital gains taxes. However, when the cost of the replacement property is less than the cost of the relinquished property, then the opposite of a 1031 exchange occurs and you still have to pay capital gains tax. As such, the $20,000 is subject to capital gains tax.
So, how does boot occur? The following are some other common instances that can bring about "boot".
- Exchanging a property that isn’t like “like-kind.” For instance, exchanging personal property for a rental property.
- Taking proceeds from the exchange in the form of a note. This is one of the reasons why a qualified intermediary is necessary.
- Cash proceeds remaining after the exchange is complete.
- Receipt of cash by the Exchange, for whatever reason, during the settlement (closing) of replacement properties.
- Taking cash proceeds from the escrow before the remaining proceeds have been sent to the intermediary.
With that in mind, here’s how you can avoid booting during a 1031 exchange.
- Bring cash to closing to pay for items that wouldn’t qualify as “like-kind”. For example, tenant deposits, rent prorations, or any vendor invoices that may be outstanding.
- Don’t create a boot by over-financing the mortgage on the replacement property.
- Increase or maintain the amount of debt on the replacement properties.
- Trade up in real estate value with at least one replacement property.
Do you plan to exchange a depreciable property during your 1031 Exchange? If you do, you need to know about some rules. That’s because swapping a depreciable property in Miami can trigger what is known as depreciation recapture.
The IRA uses depreciation recapture to collect taxes on the financial gain a taxpayer earns from the sale of real estate. Luckily, there is a way in which you can avoid this. Generally speaking, you can do so by exchanging one property for another “like-kind” one.
That said, if you swap an improved property and land with an improved land lacking a building, then any claim you may have previously made on the building could end up being considered ordinary income.
To real estate investors who own rental properties, a 1031 exchange can arguably be a great investment strategy. It’s without a doubt behind the success of countless Florida real estate investors, especially when dealing with multiple properties that qualify like a rental property. When done right it can be an excellent tax deferral strategy, however, the process can be confusing. Therefore, it's best to consult a real estate agent or property manager before making any exchanges or sales.
Please note that this guide is only meant to be informational. For further help, please hire expert services, such as those offered by Income Realty Corporation. Contact us today to discover how we can help you!