Are you a real estate investor planning to sell an investment property at any time in the future? If so, you should consider using a 1031 exchange to defer taxes on the sale of the property. This can save you thousands and help you grow your real estate investing business. Although a 1031 exchange isn’t too difficult to pull off, it requires some careful planning and execution. Here’s a quick guide to 1031 exchanges.
How Does a 1031 Exchange Work?
You’ll find the definition and rules under Section 1031 of the IRS Tax Code, hence the name “1031 exchange.” Also called like-kind exchanges, 1031 exchanges are designed for those who are selling business or investment property.
Normally, you would have to pay tax on your gains at the time of sale. Section 1031 provides the option to postpone paying tax on the gain – provided that you reinvest your proceeds in a similar type of property. You don’t have to buy a new property at the exact same time that you sell your old property. Most 1031 exchanges are delayed until you find a replacement property.
When you sell the old property, you will need to have a third-party qualified intermediary hold the proceeds from the sale. If you take possession of the proceeds, the 1031 exchange cannot continue. When you buy the replacement property, the qualified intermediary will help you complete the property purchase.
You can exchange any two pieces of real estate property in the US regardless of type. For example, you could sell a condo building and exchange it for a piece of raw land. However, both properties must be used for investment purposes or business purposes. You can also exchange a larger property for multiple smaller properties.
The Timeframe of a 1031 Exchange
As noted earlier, with most 1031 exchanges, you won’t sell and buy a property at the exact same time. It may take some time to find the right replacement property after selling off the first property. With that in mind, you’ll need to know about the 45-day rule and the 180-day rule.
- 45-Day Rule: Find a replacement property within 45 days
- 180-Day Rule: Close on the replacement within 180 days
As soon as you close on the first property, both countdowns start ticking. You’ll need to start looking for options. Once you have found a few options, you can designate them and share the information with your qualified intermediary. You must then close on one of those properties within the 180-day period. Remember, the time starts ticking for both the 45 days and the 180 days at the same time, so the longer it takes you to find a replacement property, the less time you’ll have to actually close on it.
If you fail to meet this timeline, the transaction will likely lose its qualification as a 1031 exchange, leading to a tax liability.
Benefits of a 1031 Exchange
Despite the tight timeline and potential difficulty finding the right property to invest in next, many businesses and real estate investors seek out 1031 exchanges. If you want to diversify your portfolio, invest in properties that are better aligned with your goals, and build equity over time, a 1031 exchange could be an excellent option for you.