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What is a 1031 exchange and why would you consider doing it?
A 1031 exchange is a simple way for investors large or small to increase their net worth and property holdings. For people who own propery in another state this is also a great way to move those investments closer to you.
At its most basic level its an IRS section (1031) that allows like for like-kind exchange of real estate that allows your Real Estate investment without cashing out or realizing a capital gain. It can be a powerful way to have you investment continue to appreciate tax deferred.
Heres an few examples of a basic exchange:
Scenario 1: Investor has a single family home rental property, sells it and purchases a duplex. They now go from 1-unit to 2-units all tax free and continue to build wealth.
Scenario 2: You purchased your investment property in CA perhaps when you lived in the area but have now relocated out of state. You would like your rental to be closer for ease of managment but don't want to pay the taxes that may be involved with selling it. This is a great tax deferral vehicle.
While the process is generally straight forward, there are some caveats that should be considered:
- This is NOT for your personal primary residence or use.
- This is NOT for personal property, kind of restating #1 but the IRS is not kidding. You may hear from someone that used it in the past that personal property was allowed and it was until Dec 22, 2017. You could exchange things like an airplane for a piece of property! There are a couple of exceptions but you need to consult your qualified tax professional to discuss further.
- Like-Kind is a very broad general term. An example is that you can exchange your rental property for raw land or perhaps a strip mall
- Delayed exchanges are allowed and quite common. In fact a majority of exchanges are delayed, 3rd party, or a Starker exchange (named party involved with original tax case) because closing the 2 transactions concurrently is generally not feasible. The basics of this are that a qualified intermediary will hold the cash after you sell and uses it to purchase the new property.
- You must designate a replacement property. You have 45 days to find and designate the new property. You can designate up to 3 properties but must close on one of them. Also you CANNOT handle the cash. It must go to your intermediary. If you handle the cash the 1031 exchange is null and void, putting you on the hook for capital gain taxes.
- You have 6 months to close the transaction. An important item to keep in mind is that while you have 6 months to close, if it takes you 45 days to designate a replacement property, you do NOT get 225 days to complete the transaction. The clock starts ticking when the sale of the old property is complete. So in effect if you take the full 45 days to designate you only have 135 days to close the sale of the new property.
- If you receive cash it’s taxed. This applies if you have any cash leftover at the close of the transaction and will generally be taxed as a capital gain.
- You must consider any debt carried on the property because you can get taxed if you’re not careful. This might be the most common trap that investors fail to account for. If you had a higher mortgage on the old property than you will carry on the replacement property the extra amount can be taxed. An example would be if you carried a $500K loan on a rental, sold it but only carried a $300K loan on the new property there is a $200K gain in the eyes of the IRS.
- If you are intending to use the IRS 1031 section for a vacation home/rental be very careful. You cannot move into the property right away, it takes 2 years before you use it as a primary residence along with other guidelines that must followed. Doing so beforehand can expose you to a capital gains tax. In fact call your qualified tax professional before you start this process. It can be done but but you need a professional guide.
Please let us know if you are interested in a 1031 exchange, in a simple or complex property swap. If you are simply tired of being a landlord we can help with that too! We have qualified buyers as well as investors always looking for new property.
This article is a general guideline for the 1031 exchange process. Always consult a qualified tax professional before attempting do a 1031 exchange. It can be financially rewarding but if not done correctly can expose you un-necessary taxes.
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A 1031 exchange is a simple way for investors large or small to increase their net worth and property holdings. For people who own propery in another state this is also a great way to move those