A 1031 exchangeis named after Section 1031 of the United States Internal Revenue Code. It is a tool that helps you defer paying taxes on capital gains.
With the help of the same, you can leverage to sell a property you bought for investment purposes. When you do so, the proceeds you get from the transaction can be reinvested in a new property. This invariably defers the tax liability. We will discuss the following points hereunder-
What is a 1031 Exchange?
The 1031 exchange is also known as a ‘like-kind exchange.‘ As mentioned above, it is a powerful tool or, more appropriately, a strategy for tax deferment. The strategy is extremely popular with the real estate investors. However, the keyword ‘like kind’ usually implies the property’s nature or character but not the quality or the grade.
A wide variety of properties could be included in the like kind category. Until the market value of each successive property increases, it can be considered a like-kind property for an indefinite period. Also, if the combined net market value in case there are many replacement properties.
How does the 1031 Exchange Work?
When you attempt a 1031 exchange, it can take a lot of work. This is mainly because of the complex procedures and the 1031 exchange rules. But if you are well versed with the procedure and the guidelines, it can be a seamless process throughout. To carry out the process, you can follow the steps below-
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Identify the Property You Wish to Sell
Essentially, the property you wish to sell must be an investment. It must not be your primary residence, and the property must have been appreciated since you bought it. This will ensure that you can enjoy the full benefit of the process.
Once you have decided to sell the property, you must hire the services of a QI, also known as a qualified intermediary. This step is mandatory, as per IRS norms. As a seller, you are not supposed to touch the proceeds from the sale until you invest in a new property. The funds are usually with the QI during the transaction.
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Look for Replacement Properties
You are given 45 days from the time you sell the property to the time you buy another one. This time is allotted to find as many as three replacement properties, as long as the value of the property is not more than 200% of the property value you have sold. Once you have identified the property or properties, inform the QI.
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List Your Property for Sale
Finally, when your property is sold, the proceeds (after deducting any amount towards debt to pay off) must go to the QI. Make sure the proceeds are not deposited into your bank account; otherwise, they will not meet the criteria for qualifying for the 1031 exchange.
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Form 8824 is to Be Filed along with Taxes
You must include Form 8824 when you file your taxes for the year when the exchange occurred. This will keep the IRS informed or notified of the details of the property you sold and bought as a 1031 exchange.
Requirements
Although the process is simple and can help you defer payment of taxes on capital gains, it is effective only if you meet specific requirements and adhere to them. The process is bound by stringent norms that the IRS has laid down. These requirements are as follows-
- Like-Kind Property – The properties involved must fall within the purview of like-kind property.
- Business Property – Residential property will not meet the criteria for the 1031 exchange. It is only for properties used for investment, trade, and business.
- Same Taxpayer – The name and tax return that appears on the property title that is being sold should be similar to the tax return and title holder intending to purchase the property.
- Equal or More Excellent Value- As a rule, the property’s equity and net market value must be similar to, or more than, the property that has been sold.
- No ‘boot’ – The word usually refers to any additional amount you might receive during the transaction, which may be in the form of cash, debt relief, or funds for improving
- All Equity Must Be Invested – As per 1031 exchange rules,the equity you receive from selling off the property must be reinvested as a whole in the replacement property. Failure to do so may either attract taxes or not qualify you for the 1031 exchange
What are the 1031 Exchange Rules?
You must adhere to strict timelines and norms to make the exchange rule a success. These are as follows-
- 45-day identification period
- 180-day purchase period – This is the second timeline. It kicks in from the day your property is sold. During the period, you are expected to zero in on at least one or more properties.
- Personal property does not qualify – 1031 exchange does not apply for primary residences.
- Entire reinvestment needed to avail of tax benefit
- Reverse 1031 is possible. In this state, you buy the replacement property first and then sell off the property you wish to replace. This is known as the reverse 1031 exchange. Almost all the exact requirements and rules apply under this condition as well.
Every term mentioned above is instrumental in allowing you to get the best deal and the best replacement property terms. Not only that, but most importantly, it validates the requirement for the 1031 exchange.