7 BEST Facts 1031 Exchange in Real Estate
7 BEST Facts 1031 Exchange in Real Estate
Below are the 7 BEST Facts 1031 Exchange in Real Estate:
What is a 1031 Exchange in Real Estate
The concept itself is simple: Reinvest the proceeds from the sale of a business or investment property into a like-kind investment in order to defer paying capital gains tax.
How exactly does a 1031 exchange work?
Say, for instance, you buy a property for $200,000 that is worth $500,000 by the time you sell it down the road.
Rather than paying capital gains on the $300,000 the house has appreciated, a 1031 exchange would allow you to reinvest the proceeds from the sale into another piece of real estate.
As a general rule of thumb, investors should remember that the replacement property must be of equal or greater value (net of closing costs) than the relinquished property, and all exchange equity must be reinvested for the full tax deferral.
To put it simply: trade up, and get no cash out.
Benefits of 1031 Exchange in Real Estate
The 1031 tax deferred exchange is one of the most powerful revenue maximizing tools available to owners of personal and real property held for business or investments purposes, and yet it remains one of the most misunderstood and underused sections of the tax code.
Entering into a 1031 like-kind exchange allows investors to preserve the gross equity from the real estate investment.
These may be more appropriate for an active, experienced real estate investor who has the resources and long-term timeline required for continuing oversight and management.
Want to invest in a market with growing potential? Like-kind exchanges aren’t constrained within state lines. This means you can capitalize on one of real estate’s best advantages, which is the diversification of risk.
Getting your foot in the door of an up-and-coming market early could lead to bigger returns down the road.
A 1031 deferred exchange lets you trade up to a property or portfolio of properties with higher returns or qualities that better match your investing goals — and you won’t have to pay tax on the new investment until you sell (unless you choose to do another 1031 exchange).
Purchasing a portfolio of single family rental properties gives you the flexibility to sell portions of your assets over time, on your time.
One of the great things about single-family rental properties is the ability to accessorize.
Commercial real estate typically trades in one big lump, which can create liquidity constraints. Single-family homes can be traded in smaller amounts, which provides flexibility and freedom.
1031 Exchange Requirements
While a 1031 Exchange can carry substantial benefits, there are certain requirements that must be taken into account, as improper execution could cause an investor to miss out on the tax advantages of the exchange. These include:
Capital gains tax – A property seller undertaking a 1031 Exchange is liable to pay capital gains tax on the difference in value between the sale property and the replacement property. If there is a difference in the mortgages, this can reduce the expected tax benefit.
Third-party facilitation – Investors interested in a 1031 Exchange must use an external third party to facilitate the exchange. Reliance on another party incurs higher fees and more processing time.
Like kind requirement – This requirement means that a property asset that is sold must be exchanged for a similar type of asset. Properties do not have to be the same value or condition, but for instance a property owned in the United States could not be exchanged for an international property.
Timelines to Complete a 1031 Exchange
The IRS defines the specific limits on the timeline for completing a 1031 Exchange. There are two important dates that must be met to qualify for 1031 tax benefits. Both dates are triggered after the official transfer of ownership of the property being sold.
Fixed timeline – There is a fixed amount of time to complete the transaction. If the investor fails to meet any of these deadlines, they will lose tax exemption eligibility.
Identification of replacement property – There is a 45-day window after the sale to identify a replacement property. During this identification period, the investor can typically select up to three potential replacement properties.
Completion of sale – There is a 180-day window after the sale to close on the new property. All paperwork and inspections must be completed within this six-month time frame. Investors who meet both criteria will then be able to realize the capital gains tax advantage.
EASY 1031 Exchange Explained
NET SELLING PRICE (NSP)
To avoid capital gains tax on the sale of your relinquished property, you must spend an amount equal or greater than your net selling price. (NSP equals selling price minus title fees and realtor commissions)
WHAT PROPERTIES QUALIFY
All real estate can be exchanged as long as it is held for investment or for productive use in a trade or business. House=Duplex=Land=Condo=Business Land=30-Year Lease=Deed for Deed
YOU MUST USE A QUALIFIED INTERMEDIARY (QI)
The regulations require that you use a QI to facilitate your exchange. Your QI does three main things: prepares the exchange agreement, escrows the proceeds after closing of the relinquished property, and coordinates the exchange with all closing agents.
You have 45 calendar days from closing on the sale of the relinquished property to identify up to three replacement properties. If you wish to identify more than three replacement properties, restrictions will apply.
You must close on one or more of your identified replacement properties within 180 calendar days of closing on your relinquished property.
How to do 1031 Exchange Real Estate
As you can ascertain from the above, a 1031 exchange is a powerful financial vehicle with which to grow wealth while deferring the payment of capital gains taxes.
While we have put most of the specifics in very general and easy terms to understand, there many more complex scenarios depending upon the type of property you own, how long you have owned it and what your overall tax situation is.
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