What is 1031 Exchange?

A 1031 exchange is a real estate investment tool that allows taxpayers to defer capital gains taxes by swapping one investment for another, as defined under Section 1031 of the Internal Revenue Code (IRC).

Understanding the 1031 Exchange Process

A crucial concept in property management and investment strategies is the 1031 exchange, also known as a Tax Deferred Exchange. The Internal Revenue Code (IRC) Section 1031 defines a 1031 exchange as a real estate investment tool that enables taxpayers to defer capital gains taxes by swapping one investment for another.

Essential Guidelines for Executing a Tax Deferred Exchange

For a 1031 exchange to become valid, the following IRS rules must be met:

  • Investors must hold the exchanged property for investment or business trade use.
  • Investors must exchange the property for another of like-kind.
  • Investors must complete the real estate transaction within 180 days from selling the original property.
  • A qualified intermediary must complete the exchange.
  • The two parties involved in the exchange must not be related to one another.
  • The buyer must purchase a property of equal or greater value than the original property.

How the Exchange Affects the Buyer

A 1031 exchange structures slightly differently than a typical real estate purchase. Firstly, buyers who have sold their original property cannot hold the proceeds for their purchase. Instead, they must hire a qualified intermediary, a third-party agent, to hold the proceeds that will be used to buy the property from the seller.

How the Exchange Affects the Seller

If a seller is selling a property used for investment or business purposes, they may be able to defer the capital gains taxes by re-investing the proceeds into another like-kind property. They have 45 days to identify a replacement property and 180 days to complete the purchase.

Examples

Here are a few examples of how a 1031 exchange can be used:

Example 1:  An investor owns a rental property they want to sell. The property has been owned for two years and has a basis (cost) of $100,000. The property is sold for $200,000. The investor would like to purchase a new investment property.

The investor finds a property they want to purchase for $300,000. Using the 1031 exchange, the investor can sell the rental property and buy a new one without paying capital gains taxes on the $100,000 profit.

Example 2: An investor sells a rental property for $200,000 and uses all the proceeds to purchase a new rental property. The 1031 exchange allows investors to defer capital gains taxes on the $200,000 profit from selling their original property.

What Happens When You Sell a 1031 Exchange Property?

When you sell a property purchased through a 1031 exchange, you must pay capital gains taxes on the sale. This is because the exchange only defers the taxes; it does not exempt you from them forever. However, you will be able to defer paying taxes on the sale if you re-invest the proceeds into a new investment property.

What is a Reverse 1031 Exchange?

In a reverse 1031 exchange, an investor acquires a property before they sell another one. It could be used if an investor wants to purchase a property but does not have a suitable property to sell first.

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