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1031 Exchange

1031 Exchange Defined

Section 1031 of the IRS tax code lets investors sell one investment property and use the money they get to buy another investment property. This way, they can delay paying taxes on the profit they made from selling the first property.

To make this work:

  1. The property they sell (called the “Relinquished Property”) and the one they buy (called the “Replacement Property”) must be similar types of properties. They don’t have to be exactly the same but should be used for business or investment, like a store or a rental property.
  2. The investor needs to follow specific rules to make sure it’s a real exchange and not just a regular sale. They usually need to involve a middleman to hold the money from the sale until they use it to buy the new property.
  3. The investor should be planning to use these properties for their business or investments, not for personal reasons like living in them.

Reasons to Exchange

Defer taxes (up to 35-40% of the gain)

Diversify or consolidate a real estate portfolio

Switch property types

Greater purchasing power

Build & preserve wealth

Expand into other real estate markets nationally

Improve cash flow

Greater appreciation potential

Estate planning for heirs

The Exchange Process

  1. Sale Agreement: You (the person doing the exchange) agree to sell your current investment property to a buyer.
  2. Qualified Intermediary: You team up with an intermediary, which acts as a middleman to help with the exchange. You transfer your rights to sell the property to them.
  3. Closing of Current Property: When you sell your current property, the money from the sale goes to an intermediary. They then tell the person handling the sale (the settlement officer) to transfer the property directly to the buyer.
  4. Identification of New Properties: Within 45 days of selling your current property, you need to write down the properties you might want to buy as replacements.
  5. Time Limit: You have a maximum of 180 days to actually buy one or more of these replacement properties. This period can also extend until your tax filing deadline (including any extensions) for the year you sold your old property.
  6. Purchase Agreement for Replacement Property: You sign a contract to buy one of the replacement properties from a seller, and you give your right to buy this property to an intermediary.
  7. Closing of Replacement Property: When you buy one of the replacement properties, the intermediary uses the money from the exchange to complete the purchase. They also tell the person handling the sale (the settlement officer) to transfer the property directly to you.

A 1031 exchange involves selling your old investment property, working with an intermediary to handle the money and paperwork, identifying potential new properties within 45 days, and then buying one of these new properties within 180 days to defer your taxes.

Exchange Requirements

To avoid paying capital gain taxes during an exchange, follow these rules:

  1. When you buy new property (Replacement Property), make sure it’s worth as much as or more than the property you sold (Relinquished Property).
  2. Put all the money you earned from selling the old property (equity) into the new property.
  3. Get a loan on the new property that’s as big as or bigger than the one you had on the old property.
  • Exception: If you reduce the amount you owe on the new property (debt), you can compensate for it by adding more of your own money (cash) into the exchange. However, if you increase the debt on the new property, it won’t help you make up for a reduction in the money you’re using for the exchange.
  • Calculating Capital Gains Tax: When you sell an investment property, you’re taxed on the gain you made, not just the profit or the amount of money you have left (equity) after the sale. This gain is subject to both capital gain taxes and recapture of depreciation tax.
  • Important Note: It’s possible for an investor to end up owing capital gain taxes even if they didn’t make much profit or have a lot of equity left from the sale. This is because the tax is based on the gain, not just the financial outcome of the sale.
  • Consultation: It’s a good idea for investors to talk to tax or legal advisors before going ahead with an exchange. They can provide guidance and ensure you make informed decisions regarding your tax obligations and the exchange process.