When a business owner or investor sells a piece of property, the taxes on that sale can be significant. Using a 1031 exchange can help you defer tax payments, under qualifying circumstances. Here, we will explain how this process works and help you understand the basics of 1031 exchanges.
WHAT IT IS
The 1031 exchange gets its name from Internal Revenue Code Section 1031. Under this law, a taxpayer can postpone taxes from the sale of an investment or business property by reinvesting those earnings into another property or properties of equal or greater value to the one sold.
Some of the most common properties exchanged include:
• Apartment buildings
• Retail shopping outlets
• Office buildings
• Duplexes and triplexes
• Industrial buildings
Exchanges once were allowed for any type of investment property, including vehicles, collectibles, equipment, and even patents. Because of changes made by the Tax Cuts and Jobs Act of 2017, exchanges of personal property and intangible business resources are no longer permitted.
To qualify as a 1031 tax-deferred exchange, the IRS has a list of rigorous guidelines that must be followed.
• Relinquished property (any property being sold) and replacement property (the property being acquired) must be real estate, or “like-kind” assets. But exchange properties can be of different types, i.e. a duplex seller can buy a retail property, or a land seller can buy an apartment building.
• Replacement property should be of equal or greater value, though that value can be spread across several properties. If replacement property is of lower value, you will be taxed on the difference.
• The most common type of property ID is the Three Property rule. Here the property seller can identify up to three replacement properties within a 45-day window, which includes weekends and holidays. This timeline is activated as soon as your relinquished property sale closing occurs.
• Any replacement property or properties must be fully purchased within 180 days of the relinquished property’s sale. This includes an official transfer of ownership title.
• You are prohibited from holding any money from the sale of the relinquished property you want to exchange. A qualified intermediary, or accommodator, is required to hold onto your money until the new property is purchased.
Failure to follow these regulations will repudiate the 1031 exchange provision, resulting in tax impositions.
The most obvious benefit of a 1031 exchange is the capital gains tax deferment. By delaying (or ultimately eliminating) the tax burden, you will have more money available for your next investment or investments.
Additionally, a 1031 exchange can be reapplied any time you sell a property. This allows you to increasingly trade into investment properties and significantly grow your net worth.
LET OUR EXPERTS GUIDE YOU
If you have questions about whether this tax strategy can work for your investments, contact us. Tom Opsahl or John Chirhart from our team of real estate brokerage experts can help you navigate the details to ensure you understand the basics of 1031 exchanges.