While we all like to think we’re savvy investors, do you know what a 1031 exchange is? Let’s delve right in and take a look at the details so you can make an informed homeowner decision that’s right for you and your family.
What is a 1031 Exchange?
In terms of real estate, the Internal Revenue Service (IRS) offers Section 1031 which essentially allows the swapping of an investment and business property for another. Code 1031 basically says that you can defer any capital gains tax and depreciation by reinvesting the proceeds obtained from the sale of the investment or business property into the newly purchased property. If you work the 1031 scenario correctly, you may only be required to pay little to no tax when the exchange takes place, but you’re gaining tax-deferred wealth as you do so.
How Does a 1031 Exchange Work?
Technically, you can rollover gains from one property into a “like kind”, US-based property as many times as you wish. Even though you may earn money on each swap, you won’t have to pay taxes until you sell the final property years down the road. And if you’ve done it correctly, you will only have to pay one capital gains tax rate. The IRS definition of like kind properties includes single- and multi-family rentals, industrial facilities, office buildings, raw land, storage facilities, and even retail shopping centers. Generally, the replacement property you’re swapping for must be of equal or greater value than the property you’re selling.
A 1031 Exchange Can Be Tricky
While the general concept of a 1031 exchange is swapping one property for another, if you’re exchanging a depreciating property, it’s best to consult a tax professional as it could trigger a depreciation recapture which can result in financial complications to an otherwise seemingly straightforward 1031 exchange. The old rules under the 1031 code even allowed for the exchange of equipment, franchise licenses, and aircraft, but no more, so don’t take the advice of someone who’s gone down this avenue previously as the IRS rules changed recently. And while planning in advance is the key to any successful 1031 exchange, there aren’t any guarantees that the IRS will approve each swap, nor that those tax laws won’t be changed or that the applicable IRS law(s) will apply to future cases.
A Delayed 1031 Exchange
A delayed exchange is when a qualified middleman intermediary securely holds the cash you received from selling your property and uses it to buy a replacement property, which then qualifies as a 1031 exchange. However, there are 45- and 180-day rules that must be adhered to in order to further qualify, which includes identifying the replacement property and closing the financials within the allotted timeline. If there’s money left over from the swap, the middleman is required to pay you what may then be considered as a capital gain, which could be taxable. Hence, the need to consult a professional tax advisor in some 1031 exchange cases. Not sure who to call? Consult our DomiDocs’ list of trusted nationwide service providers near you.
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Author – Connie Motz