Important Timing in a 1031 Exchange
Savvy financial investors are always looking for ways to boost investments and improve their bottom line. Many financially successful investors take advantage of a 1031 Exchange, a tax-deferment strategy, defined under section 1031 of the IRS Code. If you are considering a 1031 Exchange but don’t know much about it, read on to learn the rules and regulations.
1031 Exchange Definition
A 1031 Exchange is also sometimes referred to as a “Like-Kind Exchange” or a “Starker Exchange.” The basic definition of this IRS code is that it allows an investor to defer paying capital gains taxes when selling an investment property, as long as another “like-kind property” is purchased with the profits from the sale of the first property.
There are a few instances when a 1031 Exchange can be to your advantage. Let’s say you are ready to sell an investment property – even if you weren’t the original purchaser of the property, you are now responsible for paying capital gains taxes. You also happen to own a rental property that is now worth a lot more than you originally paid for it (even if you aren’t the original owner). In this example, executing a 1031 Exchange could both save you and make you a lot of money.
Four Types of 1031 Exchanges
The most common types of exchanges include simultaneous, delayed, reverse and construction/improvement.
A simultaneous exchange gives investors an opportunity to relinquish and close on a replacement property in the same day. This is probably the least common type of exchange because it is very rare that two exact properties are ready to be exchanged on the same day. However, this was the original intent of the 1031 Exchange, a direct exchange between two parties.
A delayed exchange is perhaps the most common exchange chosen today. This gives investors a maximum of 180 days to find a replacement property after the sale of their property.
A reverse exchange is a bit more complicated and requires extra leg work for investors to make it happen. The theory behind this exchange is that you buy right out of the gate and then pay later. The catch is that this exchange requires an all cash purchase and you won’t be able to get the bank to fund a loan because you can’t be named on title for a replacement property and a relinquished property at the exact same time. To make this work, investors need to form an LLC to take the title to the replacement property. Once the sale of the original property is complete, all they need to do is transfer the title of the replacement property back into their name.
A construction/improvement exchange allows an investor to use remaining funds to build or improve upon the property they purchase.
1031 Exchange Rules
The first rule goes back to the definition of the 1031 Exchange – the property that is being sold and the one that is being acquired must be of “the same nature or character, even if they differ in grade or quality.” What does that mean? It means you can’t exchange property for another type of asset. It’s also important to know that you can only take advantage of a 1031 Exchange for an investment or business property and not for personal property.
In order to completely defer all of the tax on the sale of the property, the IRS requires that the net market value and the equity of the property you purchase must be the same or greater than the property you are selling.
A key rule to note is that the taxpayer can’t receive what is referred to as “Boot” from a 1031 Exchange to be tax free. For example, if the new property you want to purchase is of lesser value, you can only do a partial 1031 Exchange. The difference in the amounts is called “Boot” and is the amount you will be required to pay capital gains taxes on.
So, how much time do you have to find those replacement properties? You have 45 calendar days after the closing of the first property to identify up to three properties of like-kind. However, there is an exception to this rule. An investor is allowed to identify four or more properties, so long as the value doesn’t exceed 200% of the value of the property that was originally sold.
In order to actually qualify for a 1031 Exchange, the exchange must happen no later than 180 days after the sale of the exchanged property or the date the income tax return is due for the tax year that the relinquished property was sold, whichever happens first.
Commercial and Residential Real Estate Services
If this all seems complicated and a bit overwhelming, it might be a good idea to talk to the right real estate professionals who can answer your questions. Our experts at Peak 1031 Exchange combine their exclusive lists of motivated investors and an unmatched expertise in local markets with the investor resources of the Peak Corporate Network. Peak professionals make buying or selling a property easy-to-understand and stress-free while providing clients with unique insight to make better decisions.