1031 Exchange: A Program with Benefits

Whether you are new to the real estate business or a seasonal investor. The 1031 exchange is a tax provision that you should know about.  We’ll explore the 1031 exchange concept and look at how it can benefit those in the real estate sector so you’ll have a better idea of how you can benefit from it.

What is a 1031 Exchange?

1031 Exchange or Section 1031 is a provision in the Internal Revenue Code that allows for property owners to defer taxes.   In other words, it permits the property owner to swap one investment property with another. With the 1031 exchange, the property you want to sell is called the” relinquished property” and the property you buy is called the “replacement property.”

You earn a profit from the sale of the property. 1031 Exchange is primarily for investment and business properties. But there are ways that you can use it for former primary residence and vocational homes.

As a result, you have to pay the capital gain tax on the profit, which can be anywhere from 10% – 15% of the profit earned from the sale. 1031 Exchange provides a window that allows you to postpone paying the capital gains tax if you reinvest the money in a similar property.

In order to qualify for the 1031 Exchange, you will need to:

• Purchase a property of equal or greater value;
• Purchase a similar property as the one that you sold; and
• Complete the purchase process within the period specified by the 1031 Exchange.

 

Meeting this criterion will qualify you for either no capital gains taxes or a reduced tax rate at the time of exchange. The best feature of the 1031 exchange provisions is there is no limit to how many times you can exchange property. You can avoid paying taxes for as long as you are swapping out a property, and you’ll only have to pay the capital gains taxes when you decide to sell your property for cash. The maximum benefit comes when you only have to pay the capital gains tax one time.

Here’s an example: You purchase a property for $200,000 and then sell it for $600,000. You’re responsible for paying the capital gain tax on the $400,000 earned from the property sale. With a 1031 exchange, you can buy a property using the $600,000 sales price and pay no capital gain taxes on the profit.

How 1031 Exchange Works

Let’s suppose you are selling a rental property and don’t want to pay the capital gains tax. Since the odds of finding such property are very slim, you might have to sell a property as a relinquished property.  The money you would receive from the sale would be transferred to a qualified intermediary’s exchange account. Which requires that you have a qualified intermediary escrow company. The company will hold the profit you would make from the property’s sale until you buy a replacement property.

You will then have to observe the 45-day and 180-day rules.

45 Day Rule

Once you transfer the title of your property, an intermediary escrow company will receive the cash. Accepting the cash into your account would disqualify you from the 1031 exchange benefit. You have 45 days from the date the cash is deposited into the escrow account to find another property to buy. You have to notify the intermediary escrow company in writing about the replacement property. It is better if you recommend at least three properties so you can eventually close on to one.

180 Day Rule

The 180-day rule gives you 180 days to buy and close on a replacement property.

Pro Tip: To truly benefit from the 1031 exchange, time is of utmost importance—missing any of the time thresholds means you have to pay the capital gains tax.  You might feel like you have plenty of time to find a property and then close on the deal. But it is wise to work as quickly as possible to complete the exchange in order to meet the deadlines.

Restrictions on 1031 Exchange

The 1031 exchange imposes significant limitations. These include the following:

• You must buy a property of equal or greater value to the one you sold (the relinquished property).  For example,  if you sold a rental house for $200,000, you must purchase a single or number of properties worth $200,000 or more.
• The property purchased must be of the same classification as the one sold. You cannot sell a rental home and exchange it for a vocational home or a piece of land that generates no income as part of the 1031 Exchange.
• You cannot use the money you received from selling the relinquished property for any other purpose. The money must remain in the exchange’s escrow fund until you buy a replacement property. The moment you use the profits for something else. You will be subject to the capital gains taxes on the sales profit.

The Downside of the 1031 Exchange

Given the time restraints to find a property, you may end up forcing yourself to buy a property that you otherwise might not really want to buy. It happens quite often as the 45-day or 180-day countdown continues. As the time winds down, you might not be left with enough time to negotiate the property’s sales price. Therefore, it is essential to do your homework before you enter into the 1031 Exchange program.

Final Thoughts

A 1031 exchange provision is of great benefit to investors who want to take advantage of having multiple rental properties and leveraging their sales without having to pay capital gains taxes. The 1031 exchange can also help you tap into the equity you have in your current property and invest that money into a property with better growth potential.