Paying taxes is a significant part of real estate property investments. If you're planning to sell a property and gain a profit without paying hefty tax bills, the 1031 Exchange is your best friend. Most investors have realized the importance of practicing the 1031 exchange when selling a profitable property and seeking profits by deferring tax payments. The 1031 Exchange, also called a like kind exchange, can save investors up to 20% of profits by waiving capital gains tax. In this article, we'll cover exactly what is a 1031 exchange, how does it work, who can use it, and what properties are eligible.

 

Understanding 1031 Exchange

Also referred to as a like-kind exchange, it is a tax tactic that allows investors to swap one real estate investment property for another. Investors must note that the exchange property should be equivalent or higher value without paying capital profit sales tax. It receives its name from Section 1031 of the IRS (Internal Revenue Code), providing the legal base for the like-kind property exchange option. The idea of the 1031 Exchange is that investors are not cashing out the investment but interchanging it for another similar property with better facilities.

 

Purpose of Using 1031 Exchange

The benefit of using 1031 Exchange is that investors can defer paying capital gain taxes. It is as high as 20% or more at the Federal level and includes local and state taxes. It indicates that investors can save money and grow their wealth faster. Another highlighting benefit of considering 1031 Exchange is the potential to diversify the profile, upgrade properties, and move to different marketplaces without losing equities and taxes. Real estate investors have realized the importance of incorporating 1031 Exchange wherever applicable when selling investment properties. For a successful practice, real estate investors should explore what is a 1031 exchange.

 

Working Mechanism of 1031 Exchange

1031 Exchange working principle is complex; consulting an experienced tax professional is wise. IRS Publication 544 mentions thorough details and rules, but investors should know some basic regulations and steps.

 

Identifying the Property of Sale

1031 Exchange is applicable for investment and business properties. Investors should know that properties for personal use, like vacation homes and primary residences, don't fall in the eligibility category of 1031 Exchange.

 

Identifying the Property to Buy

The property sold and bought should be like-kind. This indicates that the properties should be of the same class, character, and nature but not necessarily of the same grade or quality. Investors should browse the list of like-kind exchanges and proceed.

 

Picking up an Experienced QI (Qualified Intermediary)

Qis are experts who understand a 1031 exchange and how it functions. When investors don't receive proceeds from the sale, there is no income for taxation, and this is the idea behind the 1031 Exchange. Working with a QI or Exchange Facilitator ensures that the investors don't receive premature cashing. QIs hold the capital gain funds in the escrow account until investors complete the exchange process.

 

Deciding on the amount of the Sale Proceeds toward the New Property

Investors don't have to re-invest their sale proceeds in the like-kind properties. They can defer capital profit taxes on the portion they invest in 1031 Exchange properties. If they keep some proceeds to themselves, they might have to pay capital gain tax.

 

Monitoring the Timeframe

Two deadlines need consideration.

1. 1. Investors have 45 days from the day the property is sold to identify potential replacement investment properties. They do this in writing and share it with the QI (Qualified Intermediary) or seller.
2. 2. Investors buy a new property no later than 180 days after selling the first or old property or after their tax return is due, whichever is earlier.

 

Notifying the IRS about the Transaction

Notifying the IRS is vital while conducting the 1031 exchange. Investors file IRS Form 8824, describing the properties, parties, money, and timeline.

 

Conclusion

Understanding a 1031 exchange is one of the first steps toward a successful like-kind property exchange. Investors should know the exchange process's rules, regulations, and working mechanisms. This helps them maintain a strict timeline to choose the replacement property and complete the process. Deferring tax payments is one-way investors can create wealth and diversify their portfolios.