1031 swaps as a major tax advantage…
The deferment of capital gains tax (currently 15%) on the sale of investment property can be an excellent capital-savings strategy as any property investor looks to limit their overall tax bill. The Internal Revenue Service allows for this in section 1031 of the IRS code. This sections spells out how you can carry your cost basis forward from a newly–sold property to a newly-bought property without having to pay taxes on the sale. The key is in no monetary proceeds ever touching your hands (or your accounts, or accounts of your agents). Yes, it’s complicated, and you should seek further guidance from your tax professional. However, it basically works like this:
1031 exchanges overview
The 1031 exchange, also referred to as a tax deferred exchange, is a way for you to sell one investment property, that’s “qualified,” and then buy another qualified property within a proscribed amount of time. The process of selling your property, then buying a different property, is similar to any traditional buy/sell situation, except that with a 1031 exchange, the total set of this buy/sell transaction is treated as an “exchange” – not a regular sale.
What is a 1031 exchange?
To obtain the tax advantage of deferred capital gains taxes on the sale of your investment property, you’ll need to follow two basic rules set forth by the IRS. The first is that the full purchase price of the “replacement” investment property to be bought must be a “like kind” property. That is, it must be be considered an investment property that acts in much the same way as the property you’re selling. This does not mean they have to be exactly alike. A four family house can be swapped for a small retail building that’s providing rental income…as long as they are comparable in valuation. Even if the property to be bought is worth more, there can still be a partial swap allowable. The second component of the regulations is that all the equity derived as a result of the sale of your investment property must be used to acquire the replacement like kind property. Again, no cash outs of any kind here – or you lose the ability to call it a 1031 swap! And you’ll be paying capital gains taxes on the equity pulled out as cash.
1031 exchange real estate guidelines
The 1031 swap includes strict guidelines for how the proceeds of any sale are handled. To this end, any transaction must use the services of an intermediary company that specializes in these exchanges. These companies are called “qualified intermediaries” (QI’s), and any monies flowing through from the sale must be held, and go exclusively through, the qualified intermediary. Of course, the total proceeds from any sale have to get reinvested when purchasing the new property to be an acceptable 1031 swap. Any leftover cash that comes out of the swap to you will be taxable. In addition, 1031 exchange rules require the replacement property has to have an equal or greater value of existing debt on the property than the property you sold. If not, you’ll need to put in more cash to offset the lower debt on the purchased property.
Qualified intermediaries’ roles
Agents of the property investor (such as their current attorney, certified public accountant or Realtor), cannot be a qualified intermediary for that particular investor. A qualified intermediary does not require a license (except in Nevada), however, they should be bonded and insured against any errors and omissions. A QI will write up an agreement with the client investor that will transfer the property to be sold to the new buyer, and also transfers the replacement property to the investor in escrow, until the transaction is completed. In this way, the investor never takes possession of any proceeds of the transactions.
1031 exchanges time guidelines
There are two basic timeline considerations in any 1031 swap. The first is known as the “identification period.” This refers to the time period when the investor needs to identify other potential replacement properties to place in the exchange for the property he/she is selling. Usually, only one property is selected. This time period is 45 days from the day the investor sells his investment. The second rigid timeline is known as the “exchange period.” This refers to the period between selling their investment property and when he/she actually closes on buying the replacement property. This period allows exactly 180 days in which to do so, in order to still qualify under 1031 swap rules.
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