What is a 1031 Exchange and How Does It Work?
If you own an investment property and wish to sell, a 1031 tax-deferred exchange may be a good option. This wealth-building tool can help you sell one investment property and buy another while deferring taxes such as federal capital gains taxes, state capital gains taxes, depreciation recapture, and the newly implemented 3.8 percent Medicare Tax, all of which can significantly increase your purchasing power.
Section 1031 of the IRC falls under the headline Like-Kind Exchanges. It entails transferring "like-kind" real estate properties in order to avoid paying a variety of taxes.
In general, if you hold a property for productive use in a trade or business - in other words, an investment or income-producing property - and want to sell it, you must pay a variety of taxes.
If you utilize the proceeds of the sale to buy replacement property, you'll be left with significantly less money because of the tax burden. This loss of money owing to various taxes payable can be frustrating because you're selling one property to replace it with another investment property.
Thankfully, this is where the 1031 exchange may help. This transaction allows you to trade your "like-kind" investment or income-producing property for another. It is deemed like-kind as long as the real estate is in the United States and is used in business or held for income or investment. This strategy allows you to postpone the payment of multiple tax payments.
Criteria for Eligibility
A 1031 exchange is only for property kept for productive use in a trade or business or for investment, as previously stated. This means that any real property owned for investment purposes, such as an apartment complex, a vacant lot, a commercial facility, or even a single-family dwelling, can qualify for 1031 treatment.
It's worth noting that property used largely for personal purposes isn't eligible for Section 1031 tax deferral. This would include both a primary and secondary residence. A taxpayer can exchange a vacation house in some circumstances if the taxpayer had only limited personal use of the property. A 1031 exchange, on the other hand, is not limited to real estate. Personal property may also be eligible for a 1031 exchange.
The IRS has Compiled a List of Individuals Who are Eligible for This Exchange
- Corporations, C Corporations, and S Corporations
- Collaborations (general or limited)
- Limited-liability corporations (LLCs)
- A tax-paying entity of any kind
In this approach, the rules governing who can perform the exchange and what can be traded are fairly broad, but a 1031 exchange has time constraints. The replacement property must be identified within 45 days of the initial property's sale closing.
Additionally, you are only allowed 180 calendar days between the sale of your original property and the acquisition of your replacement property. The IRS mandates that you utilize the services of a Qualified Intermediary – such as First American Exchange Company – to oversee the transaction and guarantee that all exchange requirements are completed in order to complete a 1031 exchange.
There is no income to tax if you do not receive any money from the transaction. To put it another way, you make no money from the sale. A 1031 exchange is based on this concept, and here's how to make it work:
Step 1: Find the property you'd like to buy or sell.
The properties you're selling and buying must be "like-kind," which implies they must be similar but not necessarily of the same quality or grade.
Step 2: Find a Reliable Intermediary.
On a 1031 exchange, you must engage with a qualified middleman, often known as an exchange facilitator. Until the exchange is complete, the qualified intermediary holds your funds in escrow for you. Choose the correct skilled intermediary to avoid losing money, missing important dates, or paying taxes sooner rather than later.
Step 3: Inform the Internal Revenue Service (IRS) of your transaction.
Finally, you must include IRS Form 8824 with your tax return to notify the IRS of your transaction. You'll define the properties, provide a date, explain who was engaged in the process, and indicate the amount of money invested on that form. You must meet certain conditions for both the relinquished property you sell and the replacement property you buy.
In a 1031 exchange, the relinquished property is traded for another. Phase 1 is also called a Downleg.
The like-kind lot purchased with the money from the relinquished property is referred to as a replacement property.
What is a Qualified Intermediary?
A qualified intermediary is someone or something that sells your property on your behalf, acquires the replacement asset, and then transfers the title to you. The qualified intermediary is in charge of holding the proceeds from the 1031 exchange real estate transaction so that the sale is not taxable, coordinating the transfer of funds between the investor exchanging like-kind properties and the seller of the replacement property, preparing the legal documents, and ensuring that the transaction is completed in accordance with IRS guidelines.
What Does an Intermediary Do?
- Work out the details of the 1031 exchange with you, the seller.
- Prepare the documentation for the relinquished asset as well as the documents for the replacement property.
- Give the escrow or title business instructions and the necessary paperwork for the exchange.
- In the agreement between the seller or exchanger and the qualified intermediary, create an arm's length transaction.
- Transfers to the qualified intermediary, who is responsible for transferring the asset to the buyer.
- Handles money from the sale of the relinquished property and puts it in a separate, insured account.
- During a 45-day identification period, the cash from the sale of the relinquished property are held.
- Written information on potential replacement properties is kept in this file.
- Once the replacement property has been chosen, cash is transferred and disbursed to the title or escrow firm for the replacement property's acquisition.
- By deed, conveys title to the seller or exchanger.
- Maintains accurate records for the seller.
- For interest, sends a form 1099 to the seller or exchanger, as well as the IRS if necessary.
It is Critical That You Select the Most Skilled Intermediary for Your Needs
Verify that the qualified intermediary you're considering provides the following services:
Is the qualified middleman a seasoned real estate professional? Our agents are well-versed in 1031 Exchanges and can guide you through the process.
Exams for compliance have been successfully completed.
Annual compliance examinations, such as SSAE 16, should be passed.
Transparency in transactions is important.
Is it possible to see your exchange money at all times?
You want to know exactly where your money is at all times.
Invest in safety.
Make sure your money is safe by keeping it in an FDIC-insured account.
Whether buying a home or purchasing land, you can trust the professionals at The Mountain Life Team to provide our widely-known 5-star service. To find out if a 1031 Exchange is right for your situation, contact us today. We'd be happy to speak with you and learn more about your selling goals.
To learn more about 1031 Exchanges, go to the IRS website.