1031 EXCHANGE: WHAT AND WHY?
A 1031 exchange is an transaction that entails selling one investment property in order to purchase another. When swapping your current investment property for another, you usually pay a significant amount of capital gain taxes. On the other hand, if this transaction qualifies as a 1031 exchange, you can defer these taxes indefinitely. This allows an investor the opportunity to move into a different type of investment real estate. Or you can shift your focus into a new geographic area without incurring a large tax burden.
To understand how beneficial a 1031 exchange can be for you, learn about capital gains tax on your property. This is because, in most real estate transactions where you own investment property for more than one year, you pay a capital gains tax. You are directly charged a tax on the difference between the adjusted purchase price (initial price plus improvement costs, other related costs, and factoring out depreciation) and the sales price of the property. The percentage that’s taxed on your capital gains depends on the tax bracket that you’re in. The 1031 exchange is defined under section 1031 of the IRS code, which is where it gets its name. You can learn more about 1031 Exchanges by CLICKING HERE.
REQUIREMENTS FOR A 1031 EXCHANGE
The main requirements for a 1031 exchange:
- Must purchase another “like-kind” investment property
- Replacement property must be of equal or greater value
- Must invest all of the proceeds from the sale (cannot receive any “boot”)
- Must be the same title holder and taxpayer
- Must identify new property within 45 days; and
- Must purchase new property within 180 days
A) Selecting a less-than- qualified “Qualified Intermediary.” A “Qualified Intermediary” is a professional third-party company that handles the exchange process. They help you avoid making any critical mistakes that could jeopardize your tax-advantaged sale. An incompetent Qualified Intermediary could subject you to loss of funds, lawsuits, risk of unintentional tax fraud and other problems.
B) Taking possession of the proceeds from the relinquished property. For a successful 1031 Exchange, the proceeds must be held in escrow for the seller, usually by the Qualified Intermediary. Proceeds must all be reinvested into the new property. You cannot receive boot, ie., cash, stocks, bonds, personal property.
C) Not keeping track of the exact deadlines and adhering to them properly:
– Must identify replacement within 45 days of sale of relinquished property.
– Must close replacement within 189 days of sale of relinquished property.
D) Selling or exchanging property not held for investment or used in trade or business. For instance, this includes personal use property, like a residence or 2nd home are not eligible.
E) Attempting to exchange property held in a partnership or multi-partner LLC. Ask your tax advisor about a 1031 Drop & Swap.
Consult with your tax professional before beginning a 1031 exchange. The tax benefits for this type of exchange for investment real estate is sizable. However, you must guard against making any mistakes to avoid serious penalties.