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Did you know that you can defer costly capital taxes owed when you sell a property?
No, we’re not making this up. It’s true!
We’re talking about a 1031 exchange.
A 1031 exchange is a powerful tool for real estate investors, but there are strict rules associated with it that can make it confusing and difficult.
That’s why, in this article, we’ll explain everything you need to know about a 1031 exchange.
What is a 1031 Exchange, and Why is it Used?
A 1031 exchange allows real estate investors to defer capital gains taxes under specific conditions.
It is primarily used by investors to reinvest the proceeds from selling one property and buying another property within a set timeline.
In the past, 1031 exchanges applied to a broad range of business assets.
However, the tax code now limits the application of the strategy to only real estate assets.
There are specific rules and regulations surrounding the types of real estate properties that qualify for a 1031 exchange.
The 1031 Exchange Timeline
We’re about to throw a bunch of numbers at you, so get ready!
When a current property is sold, you as the investor have 45 days to look for potential properties to reinvest in.
Additionally, you have a total of 180 days to secure the replacement property.
The entire exchange process should be finalized within this 180-day period.
Got it?
Day 0: Selling Your Current Property.
The process begins once you finalize the sale of your current property and begin the search for a new one.
Day 45: Selecting Your Replacement Property.
Within 45 days of finalizing the sale of your current property, you are then required to select your replacement property for reinvestment.
Day 180: Finalizing the Purchase of Your Replacement Property.
Once you’ve sold your current property, you have 180 days to secure a replacement.
1031 Exchange Rules
Here are the rules for your transaction to fall within 1031 exchange guidelines.
Like-kind Property
The properties involved in the exchange must qualify as like-kind.
While they don’t have to be the exact same type (i.e., both apartments), quality, or grade — both assets must be of a similar nature, and can be exchanged for each other without incurring tax liabilities.
No Personal Residences
In a 1031 exchange, both properties need to be held for productive use in a trade, business, or investment.
Personal residences do not qualify in any way.
Of Greater or Equal Value
The net market value and equity of the acquired property must be equal to or exceed that of the property sold in order to eliminate tax liability.
No Boots Allowed
In the context of 1031 exchanges, the term “boot” denotes extra value gained in a transaction other than like-kind property.
This includes cash, debt alleviation, or property enhancements.
All Equity Must Be Reinvested
When you’re selling property within a 1031 exchange, the entire equity obtained should be reinvested in the property you’re acquiring. If you withdraw equity during the replacement process, you could face taxes on the portion not reinvested.
Arm’s Length Transactions
Both the sale and purchase must be conducted at arm’s length, meaning that 1031 exchanges prohibit transactions involving family members and close associates.
Same Taxpayer Only
The name of the taxpayer, as well as the tax return details on the property that is being sold, should match those of the buyer of the new property.
This means you can’t ask a business partner or any other party to purchase the new property on your behalf.
Types of 1031 Exchange
Did you know there are different types of 1031 exchanges?
It’s true — and important to pick the one that works best for you.
Two-Party Simultaneous 1031 Exchange
These are 1031 exchanges where property owners swap deeds.
1031 Delayed Exchange
The most common type of 1031 exchange, with 45-day identification and 180-day closing periods.
1031 Reverse Exchange
This 1031 exchange involves acquiring a replacement property before selling current assets.
Construction or Improvement 1031 Exchange
This type of 1031 exchange allows improvements on the new asset using exchange equity.
How to Calculate a 1031 Exchange
Calculating a 1031 Exchange can be complex and confusing, so here’s a few online calculators that can help you:
1031 Exchange Form
You should use Sections I, II, and III of IRS Form 8824 to document 1031 or like-kind exchanges:
The Bottom Line: 1031 Exchange
A 1031 exchange is a powerful tool in your back pocket — if you know how to use it within the specific guidelines.
Use this guide during your next 1031 exchange to ensure that you follow all the steps necessary to defer capital gains — and save money in the process.
