If you are a real estate investor or own any type of real estate that produces income for you, you should be familiar with a 1031 exchange. If you are not familiar with it or are just starting out in real estate investments, it can be beneficial to read up on something like 1031 exchange for dummies. This exchange allows you to defer capital gains if you sell your investment property and use the money to purchase a new investment property. These exchanges can be very complex and must follow many different guidelines. In this article, we will go over some basics you should know about a 1031 exchange and the 1031 exchange rules.
How a 1031 Exchange Works
Typically, when you sell an investment property you will have to pay capital gains on that income. In such a situation selling a bad investment could end up costing you more in taxes than you would make on the sale of the property. A 1031 exchange prevents this by allowing you to exchange one property for another of comparable value. For example, if you have an investment property in Oceanside, but wanted to purchase on in San Diego instead, a 1031 exchange could help you to defer the capital gains.
Types of 1031 Exchanges
There are several different types of 1031 exchanges. Which one you utilize will depend on your situation. The four different types are:
These types of exchanges constitute a direct exchange of property between two parties. These are very uncommon because it is unlikely to find a property owner willing to trade their property for yours.
A delayed exchange is the most common type of exchange. It gives you a maximum of 180 days to replace your sold property with a new one.
This type of 1031 exchange allows you to buy your replacement property first, then sell your old property later. This is not very common as banks do not like to finance them.
Typically, the value of your new property must be the same as or higher than the old property to qualify for an exchange. A construction or improvement exchange allows you to purchase a new property of a lesser value and use the remaining funds to build or improve on the new property and simultaneously defer capital gains.
Basic Rules of a 1031 Exchange
Before you undertake a 1031 exchange it is important that you understand the rules surrounding them. If you do not execute your exchange according to the rules it could cost you your beneficial tax status.
Rule 1: Exchange Must be “Like-Kind”
The property that you are exchanging for must be of the same nature or character as your old property, even if they differ in quality. Also, the properties must be within the United States to qualify.
Rule 2: Investment or Business Property Only
Exchanges are only valid for investment or business property. You are not able to do 1031 exchanges to swap one primary residence for another.
Rule 3: Equal or Greater Value
The value of the new property you are purchasing must be the same or greater than the property you are selling.
Rule 4: You Must Not Receive a “Boot”
If you choose to do a partial 1031 exchange and purchase a new property that has a lower value, the difference between the old price and the new price is known as the boot. You will have to pay capital gains on that amount. For example, if your old property was valued at $1.5 million and your new property is valued at $1 million, you would have a boot of $500,000. You would be required to pay capital gains on that amount.
Rule 5: Same Taxpayer
The owner of the old property and the new property must be the same person to qualify for an exchange. The only exception is for a single member “pass-through” LLC where the sole member is the same taxpayer.
Rule 6: Identification Window
After you close on the first property, you will have 45 days to identify 3 potential like-kind properties that could replace the old property.
Rule 7: Purchase Window
Your exchange must be completed no later than 180 days after the sale of the old property or by the due date of your tax return for the year of the sale, whichever is earlier.
What to do Now
Before you continue with the exchange process it is important that you meet with your qualified tax preparer to discuss how a 1031 exchange is going to work specifically for your situation. They can analyze your information and see what impact-either good or bad-it will have on your situation.
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