How 1031 Exchanges Can Benefit Property Investors
What is an IRC Section 1031 exchange?
Section 1031 of the Internal Revenue Code (IRC) allows investors to defer capital gains taxes from the sale of a real estate property if the property is exchanged (rather than sold) for another, like-kind property. Basically, by exchanging one property for another, an investor is able to roll over their investment and defer their tax liability until they eventually sell the property.
An investor has 180 days to complete the 1031 exchange transaction: 45 days to identify the replacement property followed by another 135 days to close the sale. Since the odds of finding someone with the exact property you want who also wants the exact property you have are slim (especially given the limited time frame), most investors involve a third party in the transaction. This individual (known as a Qualified Intermediary) will hold the cash for you after you sell your relinquished (old) property and use it to buy the replacement (new) property for you.
Here’s how the 1031 exchange process works:
1. The relinquished property is sold.You conduct the sale of your property, at which point the Qualified Intermediary receives the cash.
2. A replacement property is designated. Within 45 days of the sale of your property, you must designate a replacement property to the Qualified Intermediary in writing. Fortunately, you don’t have to finalize your choice at this time: per IRS rules, you can designate up to three properties as long as you eventually close on one of them. You can designate even more properties if you come within certain valuation tests.
The law states that the properties being exchanged must be “like-kind.” However, this term is regarded loosely and doesn’t pertain to the specific type of property. For example, an apartment building can be exchanged for raw land, a ranch can be exchanged for a strip mall and a business can be exchanged for another business.
3. Sale is closed on the replacement property. Once you’ve designated a replacement property, you have the remainder of the initial 180-day period to negotiate and close the sale with the owner. Once the sale has closed, the transaction is complete.
A couple of things to know about IRC Section 1031 exchanges:
Any surplus cash is taxable. If any cash is left over after the intermediary acquires the replacement property, the intermediary will pay it to you at the end of the 180-day period. This surplus cash (also known as “boot”) will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
Reduced liability is also taxable. If you don’t receive cash back from your sale but your liability goes down, that will also be regarded as taxable income. For example, suppose you had a mortgage of $1 million on your relinquished property, but your mortgage on the replacement property is only $900,000. That will translate to $100,000 of gain that’s classified as boot and subject to tax. For this reason, it’s best to find a replacement property of equal or greater value than your current one.
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