What Is a 1031 Exchange and Why Is It Important?
A”1031 exchange” is the nickname used to discuss Section 1031 of the U.S. Internal Revenue Service’s tax code. This section states that if someone buys one investment property for another via a 1031 exchange, they might have the ability to defer capital gains (or losses) that they would otherwise have to pay at time of sale.
Section 1031 applies to”land” beyond real estate, but many 1031 cases deal with buildings and land. We will only discuss 1031s in relation to real estate.
WHY IS A 1031 EXCHANGE IMPORTANT?
So why is a 1031 exchange important? It allows real estate investors to defer paying capital gains and possibly build wealth through real estate investing.
Think about it this way. If you buy a piece of property for $100,000 and then sell it for $500,000, you are subject to paying capital gains taxes on your $400,000 profit. From that $400,000, you’d lose, say, $120,000 to capital gains taxes. Using a 1031 exchange, you might have the ability to use the $500,000 to buy one or more new properties and pay no capital gains taxes at the time of sale. The sale’s proceeds fund new investment properties, which in turn may generate cash flow and value.
As you’ll eventually have to pay taxes when you sell these new properties, you may be able to create your money go further with a 1031 exchange. These exchanges matter as they can help property investors create more wealth. Investors can use 1031 exchanges during their careers to purchase bigger or better properties and potentially reap the rewards.
The brief answer: it depends. That is because the language used in the tax code is vague. Properties must be, it states,”like-kind.” States the IRS
“Both properties must be similar enough to qualify as’like-kind.’ Like-kind property is property of the identical character, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to empty land. 1 exception for property is that property within the USA is not like-kind to land outside of america. Additionally, improvements that are conveyed without land aren’t of like kind to property.”
Are you confused about exactly what”like-kind” means? You’re not alone. Says tax expert Robert Wood
“Most exchanges must only be of’like-kind’–an enigmatic phrase that doesn’t mean what you think it means. You may exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But again, there are traps for the unwary.”
This is why it is crucial to secure professional help if you’re considering a 1031 exchange–there are pitfalls aplenty even for seasoned investors.
RESTRICTIONS ON 1031 EXCHANGES
Investors should consider additional limitations, beyond the definition of”like-kind.” A tax professional will attest each one, but a few major considerations include:
You must own the real estate. Owning a share in a REIT, a fund or an LLC that owns a share in another LLC does not qualify.
You can only execute a 1031 exchange between investment properties. You can not do this with private property.
Should you exchange for a less expensive property, you’ll face tax considerations around the price difference.
You can”delay” your exchange (that most people do), where a third party acts as an intermediary between you and a prospective future buyer.
Even though you are able to delay the exchange, you will find important timing restrictions on the offer.
The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. But notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.”
There is a second deadline, too. The”property must be obtained and the exchange completed no later than 180 days following the sale of the exchanged property.”
As you can see, 1031 exchanges offer immense benefits. But their execution is tricky. If you do not get the whole deal right, you may end up paying taxes on the entire sale.
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