Buying a home today is about more than just finding an excellent location and a beautiful house. Buyers must think about future value and its importance. Personal benefit relates to the intention of the buyer. Is this the permanent family home? An investment? A fixer-upper or a chance to try flipping? Most people who consider a 1031 exchange have a short-term interest in the property.
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What is a 1031 Exchange?
A 1031 tax exchange, also known as a Like-Kind exchange, allows buyers to defer paying taxes during the process of selling and buying investment real estate.
The exchange is meant to assist real estate investors in purchasing a higher-priced property after a sale. As a concrete example, imagine an investor purchasing real estate for $300,000. A year later, he sells the real estate for $400,000 and then buys another with that $400,000. Under normal circumstances, the investor would have to pay taxes on the capital gain (the $100,000 profit), leaving little money to buy a better one.
Under a 1031 exchange, however, you can defer paying capital gains taxes on the gain until a later time and use the entire $100,000 profit to invest in another. The concept of a 1031 exchange is the trading of real estate (one bought, one sold) without reporting whether there was a loss or gain on the transaction.
In essence, this exchange allows buyers to borrow the amount of the gain from the government as an interest-free loan.
Exchange Timelines and Restrictions
With a 1031 Exchange; there is a firm timeline that must be followed between the time that real estate is sold and another exchanged. This timeline is divided into two distinct periods; Identification Period and the Exchange Period. The Identification Period is the first 45 days of the exchange; the real estate to be exchanged has to be officially recognized. As such, taxpayers who have multiple properties must identify one to proceed. Also; if Mother Nature steps in and destroys the home that was to be exchanged, 1031 will have to be dismissed. The process of exchange is very stringent.
The exchange period ends when a replacement property has been successfully exchanged with the original, not to exceed 180 days from the start of the Identification Period.
1031 Exchange Restrictions
The principles of the 1031 tax exchange have simplified since introduced. Instead of requiring that buyers sell their current property before buying a new one, the IRS has recently allowed taxpayers to complete a reverse exchange, where the buyer purchases a replacement property before selling the first property. A non-simultaneous transfer of property is known as a Starker Tax-deferred exchange. Another simplification to the process involves the definition of “real” property.
Law states that you may only exchange real property with real property. But real property includes both commercial and residential property, as well as land. This means that under certain circumstances, taxpayers may exchange residential property for commercial property. An exception is that property inside of the United States cannot be transferred, to property outside of the country. Also; the proceeds of a home sale must be reinvested within 180 days.
Following Through With a 1031 Tax Exchange
Finding a replacement property within the 45 days given by the IRS after relinquishing the first property is the hardest part. However, some guidelines can increase a person’s options. First, a taxpayer may choose up to three replacement properties, of any value, from which he/she must acquire at least one of those before the 180-day deadline. Another option; called the 95% rule, allows taxpayers to choose any number of replacement properties as long as the Fair Market Value of the properties received by the end of the exchange period is 95% or more of the total FMV of all potential properties identified.
Finally, the 200% rule permits taxpayers to choose any number of replacement properties as long as the total FMV of the replacement properties doesn’t surpass 200% of the fair market value of the exchanged property/properties.
Think of 1031 as a traditional IRA or 401k. When you sell assets in a tax-deferred retirement plan; capital gains are deferred until you cash out of the retirement plan. Same with 1031. As long as you re-invest your money in real estate, you may stall on the taxes.
Step-by-Step Process to Benefit From a 1031 Tax Exchange
A tax advisor or accountant advice
Seek advice from a tax counselor CPA to ensure that you’re doing what is most beneficial for your business.
Selling your property
Sell your first property, making sure to include a cooperation clause in the sales agreement which states that the buyer is aware that you intend to complete a 1031 exchange, and wants to cooperate with you to accomplish this at no charge. Please note that the closing agent is responsible in this case for contacting a Qualified Intermediary to order documents.
Agreement with a qualified intermediary
Enter into a 1031 agreement with a Qualified Intermediary; who will be named as principal in the sale of your sold property and the resulting purchase of a new property. The exchange agreement must meet IRS requirements regarding proceeds. Along with the transaction; the amendment to escrow is signed which names the QI as the seller. Replacement property does not need to be identified yet.
Keep in contact with the Qualified Intermediary. The proceeds from the sale go to the Qualified Intermediary. The funds will be placed in a separate market account. It is at this point that the exchange timeline begins. Written notification of replacement property must be sent within 45 days of this date.
Find a new property to buy
As a seasoned buyer’s agent can assist in finding properties to capitalize on the 1031 exchange.
Written notice of a replacement property
Send written identification of the replacement property before the 45th day to the Qualified Intermediary; the seller of the replacement property or an attorney. Everyone who signed the exchange agreement must sign this written announcement.
Agree to purchase a replacement property, again including a cooperation clause. This document will show the QI as the buyer, although the deed will reflect the actual buyer.
Transfer funds to escrow
Wait. The Qualified Intermediary will put the exchange funds and growth proceeds into escrow. He or she will send you information regarding incoming monies.
Submit form 8824 – Download
File form 8824 below with the IRS when your filing taxes; in addition to required state tax documents.