What exactly is a 1031 exchange? How do I go about doing a 1031 exchange when I'm selling a property? Let's take a look and see if we can answer these questions for you. Below you'll find the 1031 exchange rules you'll need to follow when selling your property so you can avoid a big tax payment.
This article shows you how to do a 1031 exchange and what the rules are to do a 1031 exchange when selling your investment property.
One of the greatest aspects of owning real estate is the benefits of tax deferment when you decide to sell your property. This privilege is called a 1031 Exchange or a Starker Exchange, if the exchange is delayed. So how do you got about doing a 1031 exchange exactly, let's take a look.
Essentially, a 1031 exchange is where certain types of property may defer the capital gains taxes that are usually due upon sale of the property, and instead use the money from the entire sale to buy another property. Some property owners always use a 1031 exchange and thus always avoid paying capital gains taxes - they just keep buying up - to more expensive properties. For example, say the investor owns a small condo, they'll then buy another larger condo that's more expensive and so on.
However, if you're property is your personal residence then you can't use the 1031 exchange option to defer taxes. The property usually must be a rental unit or an investment property for a year. Something you can do though is move out of the property for a year and rent it--but then you have to find a new property to live in during that time period.
Types of 1031 Exchanges:
- Third Party
- Boot added exchange - funds are added on to even out the exchange
- Two properties for one
Generally, if you exchange business or an investment property solely for a business or an investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.
This does not mean that you have to trade one property for another. Instead, you can use the capital gains earned from the sale of a revenue generating property to buy another revenue generating property. Let’s take a look at an example to better understand a 1031 Exchange and how you can easily benefit from it.
Sample: Five years ago, Gertrude bought a house for $80,000 and will soon sell it for $250,000. Her real estate broker recommended that she use Exchanges R’ Us as her qualified intermediary in a tax deferred exchange, which therefore allows her to defer taxes on all capital gains ($170,000 in this example).
Gertrude finds another house worth $500,000 that qualifies as her replacement property. All goes well with the exchange process, and Gertrude does not have to pay taxes on her capital gains.
Gertrude can repeat this process multiple times throughout the course of her life. Each of her purchases will progressively increase in value, thereby increasing her overall earnings when she opts out of the 1031 Exchange and collects her profits at a later point in life.
The only time Gertrude gets taxed on the property is when she finally collects all her profits, without further investing in another piece of real estate. But when this happens, the amount she collects is large and will definitely be worth the wait. As a result, Gertrude will retire with extensive comfort, knowing that she has a substantial nest egg that could potentially be worth millions - or this is passed along to another family member or business partner and no capital gains are paid.
All this sounds simple and highly advantageous, right? Well, it is—but there are a couple easy rules to follow.
First, you must complete the transaction within a designated amount of time, usually 180 days without the possibility of extensions.
Second, you are not permitted to touch the money generated by the sale of the first property. The reason for this is that there are companies and/or people who serve as “intermediaries” in exchanges. Their job is to hold the funds from the sale of the first property and then transfer them to the seller of the second property you plan to purchase. Unfortunately, though, a few problems with this system have arisen.
Recently, there have been a number of instances when the intermediaries suddenly “disappeared,” and took with them all funds they were holding. Investors lost substantial amounts of money, sometimes up to millions of dollars worth. But it gets worse.
When some intermediaries hold their client’s money, they do so under their own name (along with their other, personal assets) and not their client’s. If, for whatever reason, the intermediary gets sued, the investor’s money is frozen. And if this freeze period lasts longer than the prescribed amount of time for exchanges, the investor loses his money completely and must therefore pay income tax on all capital gains.
EXTRA: One advantage of a Tenancy in Common is they do qualify for 1031 exchanges.
You’re now probably wondering, “Where’s the benefit in that?” Granted, this can be risky, but there’s a simple step you can take to protect your profits from these careless and criminal intermediaries. All you have to do is hold the money in an account that has been reserved for your money only and no one else’s. The account should be separate from other clients’ funds and from the intermediary’s money. It should bear your name on it as well, perhaps something like this: “Exchanges R’ Us, intermediaries for Investors Fred and Wilma.”
This account should also have your investor’s tax ID or social security number. Now, regardless of what happens to the intermediary, your money is protected and you run no risk of incurring unexpected losses and/or fees.
Why You Exchange
- Deferring tax payments (of course)
- Relocating to a new area - cold versus warm
- Gain more depreciation opportunities
- Cash flow increase
- Appreciation increase
- Taking a loss on the property
- Smaller units for one large building
- Location - closer to where you live
- Problems that you can't solve but someone else can - has the know how
Learn more: IRS Tax Tips
Related Articles: IRS Is Your Friend