WHAT IS A 1031 EXCHANGE?
A 1031 Exchange is an excellent money saving tool for a property investor.
Typically when an owner sells their investment property, the property owner is taxed on any financial gain realized from the sale.
However if using a Section 1031 Exchange, the tax on the financial gain is deferred until a future date.
This tax deferred exchange is a method by which a property owner trades one or more investment (relinquished) properties for one or more replacement properties of “like kind”, which defers the payment of federal income taxes and some state taxes on the transaction.
BENEFIT OF A 1031 EXCHANGE
The primary advantage of a tax deferred exchange is that the taxpayer may dispose of a property without incurring an immediate tax liability.
This does not mean that there will be no tax paid; it only allows the deferred tax dollar to work for another investment. The exchange must be for a “like kind” replacement.
As long as the relinquished property is exchanged for a purchase of equal or greater value, then all the tax can be deferred repeatedly, If the replacement property is of lesser value than the investor pays tax on the difference. If the taxpayer uses all of the net proceeds for anything except reinvesting in real property, they will owe tax at that time.
TYPES OF EXCHANGES
DELAYED EXCHANGE: the investor in the delayed exchange has up to 45 days from the date that the relinquished property is transferred to identify a replacement property and 180 days to close on more than one property or only close on one. This is the most common type of 1031 exchange.
REVERSE EXCHANGE: The Reverse Exchange is more complex and just the opposite of a delayed exchange. The investor acquires the replacement property first and then disposes of the original property.
REQUIREMENTS OF A 1031 EXCHANGE:
QUALIFYING PROPERTY: is any real property including but not limited to vacant land, condos/townhomes, single family homes, new construction, vacation homes and evens some personal property called “boot” may qualify
PROPER PURCHASE: Both the relinquished and replacement property must be held for use in a trade or business for investment. Property acquired to flip or resell will not qualify. A personal use/primary residence will not qualify either.
LIKE KIND: Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. All qualifying real property in the United States is “like kind” and can be exchanged for any type of property, Land can be exchanged for a single family home; commercial property can be exchanged for land and so forth.
EXCHANGE REQUIREMENT: The relinquished property must be exchanged for a property of equal or higher value, with the same or higher mortgage amount, in order to defer all the tax, There will be some tax due if a replacement purchase is less value than the relinquished property,
1031 INTERMEDIARY
Deferred exchanges are facilitated by qualified intermediaries that will assist the taxpayer in meeting the requirements of a 1031. The investor will need to hire an intermediary as they cannot personally receive any of the proceeds of the relinquished sale prior to closing.
This must be an arms length transaction...if the investor touches the proceeds that negates the ability to do the 1031. A third party intermediary must hold the proceeds if the relinquished property in an escrow account and then credit the purchase of the replacement property,
Costs will vary somewhere around a couple of thousand dollars and up, depending on the complexity and number of properties in the exchange.
In order to do a proper exchange, specific wording must be added to the contract when you purchase and when you sell a property that you wish to use in a 1031 Exchange.
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