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How to Do a 1031 Exchange in Texas

A 1031 exchange offers an opportunity to increase the value of your real estate investment portfolio by leveraging your existing real estate investments. By making a 1031 exchange, investors can essentially “swap” one property for another of like-kind to defer capital gains tax. It’s a tax deferment method that has existed in the United States Internal Revenue Code (IRC) since 1921.

Doing a 1031 in Texas involves following carefully laid-out steps based on the 1031 exchange rules set out by the IRC at the federal level rather than the state level — as surprising as that may sound.

In this article, you’ll find all the details you need to understand the basics of a 1031 exchange, the steps you need to take to take advantage of a 1031 exchange in Texas, and predictions for the future of the 1031 exchange rules in Texas.

1031 Exchange Simplified

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A 1031 exchange in Texas allows investment property owners to use earnings from their property sale to purchase another “like-kind” property. It allows the capital gains taxes owed from the sale to be deferred until a future year.

Key benefits of a 1031 in Texas are that the state does not have additional laws or regulations on this type of exchange and does not have an income tax, creating more opportunities for financial growth.

Anyone who owns real estate property for business or as an investment can take advantage of this tax break. The types of properties that can be exchanged range from agricultural to retail properties. Some property types, including principal residences, can not be used in a 1031 exchange.

Step 1: Assessing Your Need for a 1031 Exchange

If you want to grow your real estate investment portfolio, a 1031 exchange can help by allowing you to use all the funds earned from selling your current property to purchase a new, more valuable property.

The ability to use all the funds from the sale is made possible by deferring the payment of capital gains tax by following the legal and time requirements of a 1031 exchange.

Step 2: Selecting Suitable Replacement Properties

The exchanged properties must be of like-kind to take advantage of this tax deferment. Thankfully, the process of identifying a like-kind property, or properties as you can purchase more than one in an exchange, is simplified by the fact that there is a great deal of flexibility in what like-kind means.

Under the definition of this term, you can exchange properties that service different sectors and industries from what you currently own.

For example, suppose you own a quick service restaurant (QSR) property. In that case, you can use a 1031 exchange and purchase a pharmacy or bank property anywhere in the United States, including tax-free states like Texas.

This flexibility allows you to explore not only different property types but also different tax, tenant, and lease options — allowing you to shape a more lucrative and passive investment portfolio than you may have currently.

Another critical component is budgeting and financially planning the exchange of the properties. The 1031 exchange requires specific rules to be met, including the 200% rule, which limits the value of replacement property(ies) to no more than 200% of the value of the exchanged property.

Speaking with an expert on the subject can help you accurately plan and budget to avoid unintended overspending or underspending on a replacement property that may jeopardize tax deferment.

Step 3: Initiating the Exchange Process

An essential component of carrying out a 1031 exchange is using a qualified intermediary in Texas, like Net Lease Finder, who can hold the funds earned from the sale until they can be applied to purchasing the replacement property. Without this, the exchange will be invalid, and you’ll owe capital gains tax on the property sale.

To initiate the exchange process, you must notify the qualified intermediary of the sale, the identified replacement property(ies), and the replacement purchase(s) to be made within the 1031 exchange time limits in Texas. These time limits give investors 45 days to identify a replacement property from the date the sold property’s ownership is transferred and 180 days to complete the exchange from the date the property ownership is transferred.

Step 4: Navigating Texas-Specific Considerations

Texas is one of nine tax-free states, making it an attractive location for investors as it reduces the overall costs of property ownership. This does not mean that investors will pay no tax at all, as the federal level still taxes capital gains (which includes taxing the profits from a property sale). So, even in Texas, a 1031 offers a beneficial opportunity for real estate investment.

Of course, the catch with Texas being tax-free is that it’s more competitive to break into the market and that investments are not as stable as taxed states. This means you want to carefully evaluate market conditions and listings before investing.

Step 5: Due Diligence and Financial Considerations

Thorough due diligence is required to identify and purchase replacement properties to ensure that the 1031 exchange can be claimed. You need to avoid what’s called the 1031 exchange boot. This term refers to any cash you might receive from an exchange that would be taxed as capital gains–something that’s easier to incur than you’d expect. For instance, if your replacement property is less than the property you’re selling, you’ll receive taxable cash on the sale.

When budgeting for your property exchange and when claiming a 1031 exchange in your tax return, it’s important to note that you can not include all expenses you incur for selling and purchasing a new property within a 1031 exchange. This means you’ll have to pay out of pocket for costs such as realtor service fees and repairing tenant damage.

Step 6: Mitigating Risks and Ensuring a Smooth Transaction

There are many elements of a 1031 exchange that have the potential to cost you money, like failing to complete the exchange within the allotted time, not using a qualified intermediary, or even overborrowing funds/loans (which can lead to a 1031 exchange boot).

Ways to mitigate these risks include starting to look for replacement properties in Texas early, carefully budgeting, and speaking with an expert (like a broker or attorney) who can help you navigate the complexities of an exchange.

Step 7: Future Trends and Considerations

On the table for discussion is the removal of 1031 exchanges for those whose annual incomes exceed $400,000. The Biden administration has put forth the idea to help fund public services like health care, though moves have yet to be made to change the criteria and qualifications.

Even though the last few years have seen a lot of economic worry and turmoil, Texas cities have continued to hold their own as some of the top commercial real estate property investment locations. On top of this, it’s expected that any of the slowdowns seen (like those of Dallas-Fort Worth) are actually shaping up to create investment opportunities for more people. And the fact that Texas is a tax-free state likely means that this will remain a competitive and lucrative location for investors.

Of course, the commercial real estate industry is constantly changing and evolving, so investors should be keeping careful tabs on industry developments and regulations at both the state and federal levels.

Conclusion

If you’re considering doing a 1031 exchange in Texas, these are the key takeaways to keep in mind:

  • Assess whether a 1031 exchange is beneficial and in line with your financial goals
  • Start looking for suitable replacement properties that meet the criteria of a 1031 exchange
  • Find a qualified intermediary and keep them up to date as you navigate the exchange process
  • Be aware of potential 1031 exchange boot costs that may end up costing you financially
  • Stay on top of market and tax regulation updates

If you’ve been investing in commercial real estate and want to find options that offer you more financial growth and a more hands-off approach to land ownership, a 1031 exchange could help you find the right solution for you.

Get in touch with us today to grow your commercial real estate portfolio, while minimizing your tax burdens for this year..