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What You Need to Know When Completing a 1031 Exchange

What You Need to Know When Completing a 1031 Exchange

Picture it: You want to buy an investment property using the proceeds from selling another that has appreciated significantly. If you sell traditionally, capital gains tax will take a significant cut, and you might not be able to afford the new property. Luckily, there's a better approach called a 1031 exchange. Let's take a look.

Key Takeaways

  1. 1031 exchange is a real estate tool that allows investors to exchange properties without paying a capital gains tax
  2. The types of 1031 exchanges are simultaneous, deferred, and reverse
  3. A qualified intermediary is necessary for all 1031 exchanges

What is a 1031 Exchange?

A 1031 exchange offers a significant amount of tax benefits. The deferring of capital gains taxes allows for a significant amount of money to be reinvested and causes a 1031 exchange to be an essential tool in expanding your real estate portfolio. However, it is extremely important for the above rules to be followed, as a single misstep can lead to a 1031 exchange being canceled.

This real estate investing tool is useful for investors looking to swap properties without being charged taxes for the proceeds which are deferred into the future. It is named after Internal Revenue Code (IRC) Section 1031 and can be used to exchange any type of investment property for another type of investment property.

To qualify, most exchanges must merely be of like-kind—which can be confusing and doesn't necessarily mean what you think it means. Also, the IRS rules are quite lenient: You can exchange a multi-family building for land, or a single-family building for a strip mall. While it sounds like an arcane and complex tax code, it's a very popular investment strategy and it supported approximately 568,000 jobs and added 55 Billion to the U.S. GDP.

How do 1031 Exchanges work?

Let's walk through an example of this process. Let's say you own an investment property in Columbus, Ohio worth $1m. With the population increase and economic growth that Columbus has seen over the past few years, your property has doubled in value. Being the savvy investor you are, you want to sell the property for $2m and reinvest the money. However, just selling means a large portion of your profits are lost in capital gain taxes. This is where a 1031 exchange will come in handy for you, as with the tax deferral you are able to use the total proceeds of $2m from your investment property sale to buy your next one.

Different Types of 1031 Exchanges

In principle, a 1031 exchange definition stays consistent no matter how it is completed. However, there are a few different ways you can go about it:

Simultaneous 1031 Exchange

  • A simultaneous exchange is mainly self-explanatory. A simultaneous exchange occurs when the two properties in a 1031 exchange are exchanged at the same time.

Deferred 1031 Exchange

  • A deferred exchange is the most popular method of exchange as it allows the user to sell their property and use the 180-day time limit to complete the exchange
  • An investor qualifies for a deferred exchange as long as a qualified intermediary handles the money, as the government would otherwise see the money sold from the original investment to be taxable

Reverse 1031 Exchange

  • A reverse exchange occurs when the replacement property is bought before the 1031 exchange occurs.
  • This property is held by an exchange accommodation titleholder, someone who holds the properties until the exchange is completed
  • A reverse exchange still has to adhere to the 180-day rule, in which the exchange must be completed within 180 days.

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The Basic 1031 Exchange Rules

As with all IRS tax code requirements, the devil lies in the details. While this article should give you a good understanding of the basic rules, it is imperative that you speak to a professional trained in these areas, also known as a Qualified Intermediary. So a 1031 exchange may sound simple, yet there are a few rules to adhere to:

1031 Exchange Property Rules

  • The property will only qualify if it is used as an investment, trade, or business property. Property cannot be used for personal use (vacation home/residence)
  • Properties that are being exchanged must be of a similar kind in terms of classification (residential → commercial). Exchanges cannot consist of different types of property (commercial → stock)

1031 Exchange Time Limits

  • You only have 45 days to designate which property you will buy to "replace" your current property
  • The replacement property must be purchased and the exchange of the two properties must be finalized within 180 days after the sale of the original property

1031 Exchange Intermediary Rules

  • A Qualified Intermediary must be used when completing a 1031 exchange
  • You are not allowed to take control of any cash throughout the whole process, only an intermediary is qualified to do so
  • The intermediary must be "anonymous" (cannot have interacted on a business level in the last 2 years)

While the rules above may seem simple, there are many intricacies within the rules that make 1031 exchanges much more complicated. The most important and consistent details is the presence of an exchange intermediary.

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The Necessity of a Qualified Intermediary

A qualified intermediary is essential to the completion of a 1031 exchange. A 1031 exchange can be easily canceled, especially without the use of an intermediary. If at any point in the process cash is handled by the investor, the 1031 exchange can be disqualified. A qualified intermediary handles. written agreements throughout the process of a 1031 exchange in order to make sure there is no possibility of the exchange getting canceled. The intermediary is also essential in the transferring of documents throughout the process, which includes documents from any aspect of the exchange.

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