Everyone should know the 1031 tax-deferred exchange if they own investment property and consider purchasing or selling it.
A starker exchange, better known as a 1031 tax-deferred exchange, is an excellent strategy for a real estate investor to postpone paying capital gains taxes. The 1031 exchange is the most popular property exchange used by investors today.
The exchange lets an individual sell real estate and utilize the earnings to purchase another property without paying capital gains taxes right away. While it appears straightforward, you must follow some guidelines for the exchange to be legally recognized.
So, how does a 1033 exchange work? We examine how investors can use this exchange technique to their benefit.
How an Investor Can Carry Out a 1031 Exchange
1. What Properties can be Used in a 1031 Exchange?
A 1031 exchange is usually a reserve for commercial or investment properties. Personal property, such as a permanent residence or a vacation home, usually does not count.
2. Locate the Property You Intend to Buy
The properties you’re selling and buying must be “like-kind,” which implies they’re of the same sort, character, or class but not necessarily the same quality or grade.
It’s worth noting that the rule only applies within the confines of the United States, so you cannot exchange one asset for another in a different country.
3. Select a Reputable Intermediary
You MUST involve a licensed intermediary, often known as an exchange facilitator. Essentially, they hold the money in escrow until the transaction is complete, assuming you won’t conduct the sale and buy simultaneously.
4. Determine How Much of the Sale Earnings Will Go Toward the Purchase of the New Property
You are not required to reinvest the entire sale proceeds in a comparable property. In most cases, one can only defer capital gains tax on their reinvested amount.
As a result, if individuals retain some of the proceeds, they may have to pay capital gains tax on those funds immediately.
5. Stay Updated on the Schedule
An investor must fulfill two deadlines in most cases; otherwise, their profit on property sale may be taxable.
First, they have 45 days from the date they sell their property to choose a new property. Selecting the property must be in writing and shared with the seller or certified intermediary.
Second, the investor must purchase the new property within 180 days of selling their previous property or filing the tax return (whichever is earlier).
6. Keep an Eye on Where Your Money Is Going
Remember, the whole point of a 1031 exchange is that the investor does not have any income to tax because they didn’t receive any funds from the sale.
As a result, an investor gaining ownership of the cash before the exchange may disqualify the transaction and make the gain taxable right away.
7. Inform the Internal Revenue Service of Your Transaction
With your tax return, you’ll almost certainly have to file IRS Form 8824. An investor defines the properties, provides a timeframe, explains who was involved, and includes financial information on that form.
1031 Exchange Rules and Guidelines
1. The Real Estate Investment Must Be Similar
An investor must reinvest the earnings from a sale in another similar investment. The new property acquired does not have to be of the same type, grade, or condition as the old one.
Most revenue-producing commercial real estate investments in the United States are considered similar and thus eligible for a 1031 exchange.
2. Hire a Qualified Intermediary
The transaction must be done as an exchange rather than a sale to comply with IRS laws. Consider it as though you were exchanging one property for another.
Accommodators is another term used for qualified intermediaries. They are either a company or an individual who facilitates the 1031 exchange and evaluates all the requirements.
The investor does not touch the funds involved, which is vital in an exchange. Instead, the accommodator purchases the property and transfers it to the new buyer.
They will use the proceeds from the sale of that property to purchase suitable replacement property and transfer it to you from the seller.
3. Identification Period: 45 Days
While the IRS allows real estate investors considerable latitude in selecting comparable properties, there are specific deadlines to meet to avoid paying capital gains tax. To begin with, investors have 45 days to find the new property or properties they want to buy.
The 3-Property rule is the most popular in the 45-day identification timeframe. An investor can use this rule to find up to three properties they would be willing to buy in exchange for the one they just sold.
The 3-Property Rule allows this to occur regardless of the property’s fair market value.
4. Exchange Period: 180 Days
An investor must close on at least one of the properties they’ve identified since relinquishing their property and identifying other properties to acquire. They have 180 days to complete this task.
It’s crucial to remember that the 180-day window begins on the sale of the actual property. Don’t be fooled into thinking you have 180 days from the date of property identification.
Advantages of 1031 Exchange
1. Deferred Taxes
A real estate investor could be paying taxes of more than 35% of their profits. It depends on various factors, such as the state in which their property is.
A 1031 exchange permits an investor to delay these taxes indefinitely if they reinvest their proceeds in real estate.
2. Increased Cash Flow
A 1031 tax-deferred exchange can improve both cash flow and overall revenue. A vacant block of land, for example, that yields no cash flow, an investor can exchange the property for a commercial facility that does.
3. Relief for Management
Investors who own multiple rental properties have the burden of intense management and costly maintenance, leading to increased stress.
An investor can enhance revenues while saving time and effort by consolidating out of high-maintenance rental properties and into an apartment building.
4. Diversification
An investor can swap one house for many others, combine lots of property into one, and buy property anywhere in the United States, thanks to the flexibility of the exchange.
5. Accumulation of Assets
A 1031 exchange is a vital instrument for accumulating wealth. The number of consecutive exchanges is unrestricted, allowing investors to exchange into larger and larger properties over time.
Investors can leave assets to their heirs with proper estate planning, and they may obtain a “step-up in basis” of that asset to its current market value. The exchange essentially allows heirs to sell the property at its fair market value without paying capital gains taxes.
Bottom Line
If you purchase property through a 1031 exchange and then turn it into a primary residence, you must hold it for at least five years before the sale becomes wholly taxed.
Benefits like enhanced cash flow, investment diversification, and tax deferral are significant reasons for using a 1031 exchange.
A real estate investor can transfer investment properties and meet tax and investment objectives using a 1031 exchange.
