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Here’s What You Need to Know About 1031 Exchanges

A 1031 exchange is a way to exchange one investment property for another while deferring taxes on any capital gains realized from the sale as well as taxes on any depreciation recapture you experience.

Doing a 1031 exchange can help you keep more of the equity you’ve earned on the appreciation of your real estate investment. But there are strict rules surrounding 1031 exchanges.

They’re to be used to buy and sell investment properties only – if you want to perform a 1031 exchange on a primary residence or vacation property, you’re going to have to turn it into a rental for six months or a year first.

In order to perform a 1031 exchange, you’ll need to choose a qualified intermediary to work with – this person takes the cash from the sale of your investment property, holds it for you while you’re selecting another rental property to swap for, and then buys the new property using your money once you’ve designated in writing which property your intermediary should buy.

You’ll have to file IRS Form 8824 with your taxes in the year you complete a 1031 exchange. Here are the details you need to make this property exchange work for you.

How 1031 Exchanges Work

A 1031 exchange is considered a swap, but it technically involves selling your investment property and buying a new one. The transaction can be treated as a 1031 exchange for taxes only if you use a qualified intermediary to perform the transaction.

If you don’t use a qualified intermediary, follow the rules, and file the proper paperwork, your transaction won’t count as a 1031 exchange and you’ll have to pay capital gains taxes on any profits you earned from the sale. If you’ve been claiming depreciation on the sold property on your taxes, then you could recapture some of that lost value as income and you’ll owe income taxes on it.

To make a 1031 exchange work, you first have to figure out which property you want to sell, and it’s a good idea to have a property to buy in mind, too. You’ll be under a deadline to close on the purchase once you begin the 1031 exchange. Work with a qualified intermediary who can hold the funds from the sale of your relinquished property and use them to buy a new property on your behalf.

What Counts as a Like-Kind Exchange

Like Kind Exchange

Many new investors struggle with this concept when they have 1031 exchanges explained to them, but when you exchange one property for another through a 1031 exchange, the properties must be of like-kind. Many people think that means they have to exchange a single-family home for a single-family home or an office building for an office building.

But in fact, the rules are much laxer than that. According to the IRS, most pieces of real estate are of like-kind to one another. You could exchange a single-family home for a multi-family home or a developed piece of land for an undeveloped piece of land, for example. 

Timelines and Rules

1031 exchanges must move on a strict timeline. Once you have sold the property you’re giving up, you have 45 days to find up to three potential replacement properties and designate them to the qualified intermediary in writing. That’s why it’s often best to have a replacement property in mind before you begin the 1031 exchange.

You have 180 days from the date you closed on the sale of the property you gave up to close on the sale of the property you’re acquiring, so it’s best to designate a potential replacement property early.

Types of 1031 Exchanges

There are three main types of 1031 exchanges: delayed, reverse, and build-to-suit. A delayed exchange is the most common because it allows you 180 days from the sale of your old property to close on the sale of a new one. This is the type of 1031 exchange described above, in which your intermediary holds onto your money and buys your replacement property on your behalf.

If you find a replacement property before you have sold your old property, you can perform a reverse 1031 exchange. In this kind of swap, you buy the replacement property first and then sell the property to be replaced.

This can be a good idea if the market is hot, you need to close on your purchase quickly, or you’re competing with other offers. Even though the replacement property is purchased before the relinquished property is sold, you will still need a qualified intermediary to hold onto the newly acquired property for you until the relinquished property can be sold.

A build-to-suit 1031 exchange is usually used when the replacement property is to be developed or renovated. You can use some of the funds from the proceeds of your relinquished property to fund these renovations or developments. You have 180 days to complete your improvements.

1031 exchanges are a valuable tool to help real estate investors hang onto more of their wealth. The next time you want to upgrade to a better property, do a 1031 exchange. It’s like getting free money toward a down payment!

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