A 1031 exchange provides business owners and savvy real estate investors with a solution to tax problems. Suppose you buy an asset like a warehouse, an office building, a rental property, or a piece of land; it is most likely to appreciate over time. In that case, you can sell it for a profit. However, you must also pay a hefty tax bill known as capital gains tax.
The tax reduces the money you have gained from the sale, leaving you with less available cash to reinvest in another property. That is where a 1031 exchange comes in. When you execute a 1031 exchange, you defer paying the capital gains tax as long as the proceeds of the property sale are used to purchase similar reinvestment property. Therefore it provides many advantages over the regular sale.
Which properties qualify for a 1031 exchange?
Some rules apply in 1031 exchanges. The internal revenue service is keen on ensuring that the property you want to relinquish and the one you want to buy are both used for business purposes, investment, or held for productive use. That means you cannot exchange your primary residence property for a new one or a car.
For instance, you can exchange a piece of undeveloped commercial land for a tic 1031 investment, a warehouse for a rental apartment, a small apartment complex for a large rental house, etc. Also, it doesn’t necessarily have to be a one on one transaction. For example, you can sell a commercial mall to buy several rental apartments in different cities.
But you must remember that the replacement property must be of equal or greater value than the relinquished or sold property to obtain maximum tax benefits. If on a mortgage, the mortgage debt on the replacement property must be as much or more than the mortgage debt of the relinquished property.
Although the IRS gives you some time to complete the transaction, it is strict on the timeline. You have 180days to complete the 1031 exchange from the date you close on the sale of the old property. If you do not meet the timeline, you lose the tax benefits.
Moreover, the IRS also recognizes that many investors sell before finding the replacement property. So, it permits a 45days window period from the closing date of the sale for you to identify the replacement property.
Who can take you through a 1031 exchange?
A 1031 exchange can be complicated. Even so, the IRS requires the facilitation of a third party known as a qualified intermediary. It could be a bonded and insured business dedicated to facilitating 1031 exchanges. The qualified intermediary evaluates your proposed transactions, prepares the necessary tax documents, and facilitates the transaction.
They serve as an intermediary who holds the funds from the sale and purchase in escrow and facilitates the transfer of the relinquished property to the buyer and the replacement property from the seller. You should identify a reputable and established qualified intermediary, especially since they will be handling your property, money, and tax documents.
Although a 1031 exchange has many benefits, the IRS can be picky when reviewing it, so you must execute it in the right way to earn the tax benefits.