A 1031 exchange may be the ideal real estate transaction for you if you own one investment property and want to acquire another while selling your current one. A 1031 exchange is a tax-deferred transaction in which you buy another “like-kind” property to delay capital gains taxes. This trading mechanism, which may be effective in a number of scenarios, is used by some of the most successful real estate investors.
🤔 What Exactly Is A 1031 Exchange?
A 1031 exchange actually gets its name from Section 1031 of the Internal Revenue Code of the USA. The Internal Revenue Code permits an investor to avoid paying capital gains taxes on the sale of an investment property if the proceeds are re-invested in a property or properties of equal or higher value within a certain time frame.
🧑⚖ The 1031 Exchange Has Its Own Set Of Rules And Regulations
This tax-saving method works in a number of ways as long as certain limits are followed.
- It entails the sale or purchase of real estate for the purpose of business or investment. (Not eligible are houses that have been flipped.)
- If a 1031 exchange is done appropriately, an investor can do it as many times or as frequently as they like.
- The restrictions may apply to a former principal residence in extremely limited situations.
The History And Politics Of The ‘Like-Kind’ Trade
The 1031 exchange, commonly known as a like-kind exchange, has been in the tax code since 1921 and has undergone various revisions throughout the previous century. The Tax Cuts and Jobs Act, signed into law by President Donald Trump in December 2017, exempted some personal and intangible property from 1031 exchanges, limiting them to real estate transactions.
Although the Biden Administration has suggested decreasing the 1031 exchange deferral limitations to $500,000 per year ($1 million for married couples filing jointly), it’s uncertain whether this would be included in his final infrastructure plan. If the Biden limit is passed, Jeff will have to declare $200,000 in capital gains.
😵💫 Types of Real Estate Exchanges
Simultaneous exchanges are 1031 exchanges in which the sale and purchase of the properties occur on the same day. Keep in mind that this transaction must occur at the same time in order to reap the rewards. The exchange may be denied if the closure of either property is delayed for a short period of time, causing you to pay full capital gains taxes.
Three different types of simultaneous trades are possible. The first type of simultaneous exchange occurs when you exchange deeds and the second kind is a three-party exchange, in which a third party known as a Qualified Intermediary helps you and the owner of the other investment property complete the deal.
Qualified Intermediaries will oversee the entire transaction and have the requisite knowledge and experience. If you do not engage the services of a Qualified Intermediary, you risk nullifying the 1031 exchange and incurring a large tax cost.
If you undertake a delayed exchange, you will be able to renounce or sell your investment property before acquiring another investment property.
This allows you to buy something else using the money from one transaction. This sort of transaction is only possible once your house has been marketed, a buyer has been located, and a sale and final purchase agreement has been executed. The seller will then need to employ a Qualified Intermediary to retain the selling proceeds until a comparable property can be identified.
You’ll have 45 days to look for a new house and 180 days to close the deal. During this time, the funds from the sale of your prior investment property will be kept in a binding trust. While you must complete the sale of your new house within 180 days, you will only have 45 days to find an investment property. When opposed to a simultaneous deal, this time frame gives you a little more leeway.
A reverse exchange differs from a regular exchange in that it entails locating and acquiring an investment property before selling your present one. Your present residence will be sold after that. If you buy a new property first, you can wait to sell your older one until the market value rises.
The fact that this sort of transaction is frequently made totally in cash is the largest issue. It’s also worth noting that the majority of financial institutions don’t offer reverse exchange loans. Remember that if you utilize this exchange to purchase another home, you’ll have 45 days to pick which of your current investment properties will be abandoned. You’ll have another 135 days to finalize the purchase after then.
Construction Or Improvement Exchange
You can make changes to the property before the actual exchange via a construction or improvement exchange. The property will be kept by a certified intermediary for 180 days, during which time you can utilize the exchange equity to make the required changes. If you want 100% of your gains to be tax-free, you must meet three different criteria.
To begin, you must utilize all of your exchange equity as a down payment or to renovate the home within 180 days. The taxpayer must get the same property as on the 45th day, which means it cannot be significantly altered. When the item is returned to the taxpayer, it must be of equal or greater value. Within 180 days, these upgrades must be accomplished.
🤓 Getting Started With A Section 1031 Transaction
If you believe a 1031 exchange is right for you, be sure you understand and follow all applicable requirements. The first step is to seek the help of a Qualified Intermediary to complete your transaction. Whether you’re performing a simultaneous or delayed exchange, the investment property you want to acquire must be identical to the one you’re selling.
It’s also crucial that you don’t use any of your personal belongings in this transaction. Keep in mind that you only have 45 days to find a new house and 180 days to complete the switch. You may have to pay capital gains taxes if you miss these dates.
In a number of ways, these exchanges can benefit you as an investor. If you wish to diversify your assets with a new property or acquire a property with better-estimated returns, a 1031 exchange is a good alternative.
It may also be advantageous if you already manage an investment property but want to purchase one that has been managed. While you should now have a better understanding of how to begin a section 1031 exchange, bear in mind that it is a lengthy procedure with various obstacles to overcome.
😁 I hope you enjoyed this weeks blog article about What a 1031 Tax Exchange is and how to use it to your advantage. Disclaimer – I am not a Certified Public Account and the advice I have given above is my opinion