What is a 1031 Exchange?
An Essential Property Management Term
A 1031 exchange is a real estate investment tool that allows taxpayers to defer capital gains taxes by swapping one investment for another, as defined under Section 1031 of the Internal Revenue Code (IRC).
Rules of a 1031 Exchange
For a 1031 exchange to become valid, the following IRS rules must be met:
- The exchanged property must be held for investment or use in a trade or business
- The property must be exchanged for property of a like-kind
- The real estate transaction must be completed within 180 days of the sale of the original property
- The exchange must be completed using a qualified intermediary
- The two parties involved in the exchange must not be related to one another
- The purchased property must be of equal or greater value than the original property
How a 1031 Exchange Affects the Buyer
A 1031 exchange is structured slightly differently than a typical real estate purchase. First, if a buyer sold their original property, they are not allowed to hold the proceeds they will use to purchase. They must hire a third-party agent – a qualified intermediary – to hold the proceeds, who will then use the funds to purchase the property from the seller.
How a 1031 Exchange Affects the Seller
If a seller is selling a property used for investment or business purposes, they may be able to defer the capital gains taxes by re-investing the proceeds into another like-kind property. They will have a time limit of 45 days to identify a replacement property and 180 days to complete the property purchase.
1031 Exchange Examples
Here are a few examples of how a 1031 exchange can be used:
Example 1: An investor owns a rental property they want to sell. The property has been owned for two years and has a basis (cost) of $100,000. The property is sold for $200,000. The investor would like to purchase a new investment property.
The investor finds a property they want to purchase for $300,000. The 1031 exchange allows the investor to sell the rental property and purchase the new investment property without paying any capital gains taxes on the $100,000 profit from the sale.
Example 2: An investor sells a rental property for $200,000 and uses all the proceeds to purchase a new rental property. The 1031 exchange would allow the investor to defer paying capital gains taxes on the $200,000 profit from selling the original property.
What Happens When You Sell a 1031 Exchange Property?
When you sell a property that was purchased through a 1031 exchange, you will need to pay capital gains taxes on the sale. This is because the exchange only defers the taxes; it does not exempt you from them forever. However, you will be able to defer paying taxes on the sale if you re-invest the proceeds into a new investment property.
What is a Reverse 1031 Exchange?
A reverse 1031 exchange is a transaction in which an investor acquires a property before selling another. It could be used if an investor wants to purchase a property but does not have a suitable property to sell first.
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