If you’re a real estate investor, you know that the key to success is diversifying your holdings. You reduce your risk while maximizing your earning potential by owning property in different markets and states. You can also increase your profit by investing in real estate using specific tax strategies, such as the 1031 exchange.
What Is a 1031 Exchange?
The 1031 exchange allows you to trade one investment property for another without paying any capital gains tax on the sale.
The process allows you to reinvest your money in a new property and defer paying taxes on your profits until you eventually sell the new property. But you must follow specific guidelines set forth by the IRS for the exchange to be valid.
How Does the 1031 Exchange Work?
When you sell your property, the funds go into an escrow to ensure both parties fulfill your obligations. You have 45 days to look for replacement properties for the one you sold, or you’ll get taxed.
After identifying the replacement property, you have 135 days to buy it to qualify for the 1031 exchange. If you go past 135 days, you get taxed. So, you have 180 days to complete the transaction to qualify for the 1031 Exchange.
What Are the Types of 1031 Exchanges?
There are four types of 1031 Exchanges:
- Delayed 1031 Exchange – The most common type of 1031 Exchange, a Delayed 1031 Exchange, allows you to sell your property first and then use the proceeds from the sale to purchase your replacement property within a specific time frame.
- Reverse 1031 Exchange – In a standard 1031 exchange, the taxpayer should identify replacement properties within 45 days after selling the relinquished property and close on purchasing one or more of those properties within 180 days. In a reverse exchange, the taxpayer purchases the replacement property first, then sells the relinquished property.
- Simultaneous 1031 Exchange – In a simultaneous 1031 exchange, the taxpayer transfers the replacement property and the relinquished property on the same day. The taxpayer can do this through two separate transactions or one transaction with two properties.
- Construction or Improvement 1031 Exchange – In this 1031 exchange, an investor can use the sold property’s equity to improve a replacement property. A qualified intermediary holds the deed in trust for up to 180 days.
What Are the Requirements?
You must adhere to the following requirements to qualify for a 1031 Exchange:
- The property you sell must be classified as like-kind, or the property must be of the same nature, character, or utility.
- The property you are selling, and the property you are purchasing must be held for investment purposes or used in a trade or business.
- You must follow the time limits for exchanging properties.
- The property values should be equal or greater.
- You should own the property you want to exchange.
How Would President Biden’s Tax Plan Have Affected the 1031 Exchange?
The proposed tax plan of President Biden would have affected the 1031 exchange since the deferral will not be available for sales of over $500,000 for single individuals. Joint filing couples would need to have a sale of under $1 million to qualify for the 1031 exchange.
This would have been a significant change for investors who use 1031 exchanges to defer taxes on their investment properties. Fortunately, the provision affecting like-kind exchanges did not appear on the reconciliation bill of the Ways and Means Committee.
In conclusion, the 1031 Exchange is a great way to defer paying capital gains tax on your investment property. To take full advantage of this process, talk to the experts at Brisky Net Lease.