What is a 1031 Exchange and why you should use it!
A 1031 Exchange, also known as a like-kind exchange, is a provision in the US tax code that allows real estate investors to defer capital gains taxes when they sell one investment property and reinvest the proceeds into another “like-kind” property. Here are a couple examples of ways to use a 1031 Exchange. Tax referral, the most significant advantage of a 1031 exchange is the ability to for capital gains taxes on the sale of appreciated property. By reinvesting the proceeds into a like-kind property, you can postpone paying taxes until you sell the replacement property for cash. Wealth accumulation, investors can use 1031 Exchanges to continually roll over their investments into larger more profitable properties, effectively leveraging the growth of their Real Estate Portfolios without losing a significant portion of their gains to taxes. Diversification, a 1031 Exchange provides flexibility to diversify your real estate holdings. You can exchange one type of property (residential rental property) for another type (commercial property) or change properties located in different geographical areas. Estate Planning, investors can use 1031 Exchanges as part of their estate planning strategy to pass on assets to heirs with a stepped-up basis, potentially reducing the future tax burden on their heirs.
Here are seven important things to know when thinking about using a 1031 Exchange:
1. Qualifying Properties
To qualify for a 1031 exchange, both the property you’re selling (the relinquished property) and the property you’re purchasing (the replacement property) must meet certain criteria. Both properties must be held for investment or for productive use in a trade or business. Personal residence Do Not Qualify.
-Both properties must be of like-kind, which means they must be of the same nature or character. Real property (land, buildings) generally qualifies as like-kind to other real property.
2. Identification of replacement
After selling your relinquished property, you have 45 days to identify potential replacement properties. You could identify up to three properties without regard to their fair market value, or you can identify more than three properties as long as their combined fair market value does not exceed 200% of the value of the relinquish property.
3. Purchase of replacement property
Once you’ve identified replacement properties, you have 180 days from the sale of the relinquish property (or until the due date of your tax return, including extensions, for the year and in which the relinquished property was sold, whichever comes first) to purchase one or more of that identified replacement properties.
4. Qualified Intermediary (QI)
To facilitate the 1031 exchange and ensure compliance with IRS rules, you typically work with a qualified intermediary. The QI holds the proceeds from the sale of the relinquished property and then uses those funds to acquire the replacement property. You must not have direct access to the sale proceeds to maintain the tax-deferred status of the exchange.
5. Completing the Exchange
The exchange is considered complete when you acquire the replacement property within the specified timeframes. The new property should have a purchase price equal to or greater than the relinquished property’s sale price. Any funds not used to purchase replacement property may be taxable.
6. Report the 1031 Exchange to the IRS
Report the 1031 exchange on your tax return by filing form 8824. This form provides details about the exchange and calculates any taxable gain that is deferred.
7. Defer Capital Gains Tax
By following these steps, and completing a valid 1031 exchange, you will defer paying capital gains tax on the sale of the relinquished property until you decide to sell the replacement property without using a 1031 exchange.
It’s important to know that 1031 Exchanges have strict rules and requirements, and failure to comply with these rules can result in the disqualification of exchange, and the immediate taxation of capital gains. Working with a qualified intermediary and consulting with a tax professional or an attorney experienced in 1031 Exchange is highly recommended. Using a 1031 Exchange can be a powerful tool for real estate investors to grow their portfolios and defer taxes on property appreciation to build their portfolio.