1031 Exchange | The Need To Know Hawaii Real Estate Investor Strategy

Understanding the 1031 Exchange in Hawaii

1031 exchange hawaii

Hawaii is known to be one of the most equity rich states in the nation. Strong and steady appreciation rates over the last 40 years play a significant role in the appeal to investing in Hawaii but what happens when a Hawaii real estate investor decides to sell their property? If there's a gain to be had, then there's likely taxes to be paid. This is unless the investor chooses to perform a 1031 Exchange, effectively reinvesting their sale proceeds into a new Hawaii investment property without having to pay gains tax! This a huge benefit to equity conscious investors and easily one of the most powerful Hawaii Real Estate Investment strategies.

What is a 1031 Exchange?

A 1031 exchange, also known as a like-kind exchange, is a tax strategy that allows investors to sell a property and reinvest the proceeds into a similar property, without incurring capital gains tax on the sale. This can be a powerful tool for Hawaii real estate investors, as it allows them to defer tax liability and potentially increase the overall return on their investment.

What is a Reverse 1031 Exchange?

A reverse 1031 exchange is a variant of a traditional 1031 exchange, which allows investors to sell a property and reinvest the proceeds into a similar property without incurring capital gains tax on the sale. In a reverse 1031 exchange, the investor purchases the new property before selling the old one.There are a few important considerations to keep in mind when using a reverse 1031 exchange. For example, the investor must be able to demonstrate that they had a "bona fide intent" to complete a 1031 exchange at the time they purchased the new property. Additionally, there are strict timelines that must be followed in order to qualify for a reverse 1031 exchange. This is definitely the most complex type of 1031 exchange and should be handled by a polished Qualified Intermediary.

What is a Qualified Intermediary?

A qualified intermediary, commonly referred to as a "QI," is a person or organization that aids in a 1031 exchange and is essential to the 1031 exchange procedure. The selling funds are often transferred to the investor directly when an investor sells a property. In a 1031 exchange, however, the qualified intermediary keeps the sale funds until they are applied to the purchase of the new property.

This is crucial because receiving the money straight from the investor could be viewed as a "disposition" of the asset, which would result in capital gains tax. The investor can postpone paying taxes by having a competent intermediary store the funds until the new property is purchased.

What Are the Advantages of a 1031 Exchange?

Using a 1031 exchange has a number of advantages:

  • Capital gains tax deferral: As previously stated, the main advantage of a 1031 exchange is the capacity to postpone capital gains tax on the sale of a property. Investors wanting to sell a property whose value has increased dramatically may find this to be extremely helpful.
  • Potential for higher returns: By postponing capital gains tax, investors can reinvest the money from the sale of their property into a new investment property, raising the likelihood that their overall return on investment would rise.
  • Greater flexibility: A 1031 exchange enables investors to sell their current real estate and reinvest the proceeds in a different kind of property, such as switching from residential to commercial real estate. This can be a fantastic method for investors to diversify their holdings and explore other kinds of real estate.
  • Simplified process: Working with a qualified intermediary to facilitate the exchange can make a 1031 exchange very simple. Investors may find it simpler to sell their current home and reinvest in a new one as a result.
  • Using a 1031 exchange requires keeping in mind a few crucial factors. For instance, the properties in question must be of "like-kind," which requires that they be utilized for commercial or investment reasons. Additionally, in order to be eligible for a 1031 exchange, specific deadlines must be met.

How do I know if I can use a 1031 Exchange?

In order to qualify for a 1031 exchange, the following must apply or occur:

Like-kind property: The properties included in a 1031 exchange must be of "like-kind." They must therefore be utilized for commercial or investment purposes. This essentially means that any kind of property can be traded for any kind of property.

Timing: A 1031 exchange must be completed within specific time frames. After selling the old property, the investor has 45 days to find a replacement property and 180 days to finalize the exchange.

Reinvestment: The sale earnings from the old property must be put back into the new property in order to be eligible for a 1031 exchange. Additionally, the investor must receive the same kind and amount of property in return.

Competent intermediary: The trade must be facilitated by a qualified intermediary. Until they are utilized to buy the new property, the intermediary keeps the money from the sale of the previous property.

Same taxpayer: In a 1031 exchange, the identical taxpayer must be the owner of both the old and new properties. This means that property cannot be transferred to a different owner through the exchange.

Personal use: During the previous 12 months, the properties up for exchange could not have been utilized for personal purposes.

What is Hawaii Capital Gains Tax?

The profit you get when you sell an item with higher value is subject to capital gains tax. The tax is calculated on the difference between the asset's selling price and its "basis," which is typically the price you bought for it.

For illustration, suppose you paid $1,000 for a stock and later sold it for $1,500. Capital gains tax is due on the $500 profit you made from the transaction.

The capital gains tax rate is determined by your tax bracket, as well as how long you owned the asset before selling it. Gains on assets held for a year or less that are considered short-term capital gains are taxed at your regular income tax rate. Gains on assets held for longer than a year are considered long-term capital gains and are taxed at a lower rate.

Long-term capital gains come in two flavors: 0% and 15%. Taxpayers in the 10% and 12% tax brackets pay no tax, while those in higher tax brackets pay a 15% tax. Additionally, there is a 20% rate for some high-income taxpayers.

Not all assets are liable to capital gains tax, which is an important distinction to make. For instance, the majority of personal property, including clothing and furniture, is exempt from capital gains tax. Similar to this, assuming you meet certain criteria, such as residing in the dwelling for at least two years, your principal residence is typically exempt from capital gains tax.

Understanding how capital gains tax functions and how it could effect your profits will help you make better investing decisions. A tax expert should be consulted if you have any doubts about capital gains tax.

In general, a 1031 exchange can be an effective instrument for real estate investors seeking to postpone tax obligations and possibly boost earnings. Working with an experienced tax professional is essential if you're thinking about doing a 1031 exchange to make sure you are adhering to all applicable rules and laws.

Can I do a 1031 Exchange into a DST?

Yes. This is also a great backup replacement option should you fail to find a replacement property before the deadline.  A DST, or Delaware Statutory Trust, is a type of trust that is used in commercial real estate transactions and allows multiple investors to hold ownership interests in a property. A DST can be helpful for smaller investors who may not have the financial resources to purchase an entire property on their own. It is typically managed by a professional trustee, who is responsible for overseeing the property and making decisions on behalf of the investors. A DST can also generate income through rent or capital appreciation, which can be distributed to the investors. 

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