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How Do 1031 Exchanges Work?

What Is an IRS 1031 Exchange?

IRS tax code section 1031 states that an individual is allowed to defer capital gains tax upon the sale of an investment property. This holds true when the profits from the sale go directly towards the purchase of a “like-kind” property. Naturally, the odds of two sellers being interested in the other’s property is low. So, since most 1031 exchanges are delayed how do 1031 exchanges work? A third-party exchange agent will hold onto profits from the sale of your property. Subsequently, they then purchase another property with those profits once it has been found. Legally speaking, the IRS still recognizes this as an “exchange” under 1031 law.

What is Meant By “Like-Kind”?

Before 1984, 1031 exchanges had to be exact. If, for example, you were selling a three-story office building, you must in turn be purchasing another three-story office building. Now, the like-kind concept is far broader, making it easier to comply to. According to the IRS, assets must be “similar in like or nature, even if they differ in grade or quality.” As an example, you could exchange a commercial building for a single-family rental. However, you could not trade commercial farming operation for a restaurant.

To completely avoid capital gains taxes at the time of sale, the property purchased needs to have equity and a net market value greater than or equal-to the property sold. If this is not the case, the cash profits are taxable. This isn’t a bad choice for those who are interested in making a profit and are unconcerned with having to pay some taxes. The best way to avoid capital gains taxes, however, is to purchase several properties whose combined value is greater or equal-to the property you sold: you can purchase as many properties as necessary to make the exchange.

What are the Benefits of a 1031 Exchange?

While deferring capital gains taxes is a tempting benefit in itself, 1031 exchanges are also great for other reasons. Afterall, an investor could continuously make 1031 exchanges until their passing. These exchanges prove useful for growing wealth and creating a robust investment portfolio. Poor exchanges could always be exchanged for stronger ones, and great investments could be supplemented by other smart investments. It allows for tax-free diversity within one’s portfolio, making it a vital tool in many estate plans.

Are There Any Important Deadlines?

It is important to keep in mind specific deadlines that come with 1031 exchanges. The former owner must identify up to three potential properties, or property combinations, within 45 days of the closing of their previous property. The “200% rule” is an exception to this, allowing one to identify four properties, so long as the combined value of the properties does not exceed 200% of the sold property’s value.

There is a six-month (180 day) deadline for purchasing the new property or properties. The deadline starts on the day of the old property’s closing. The only way to circumvent the 180-day rule is if the property owner extends his tax return. In this instance, the 180 days begins on the day of the extension.

While IRS 1031 exchanges cannot be used on personal property—except sometimes for vacation homes—it can be a valuable tool for investors looking to save money and grow wealth. For additional information on 1031 exchanges, or to speak with a legal representative experienced in real estate law, contact James A. List today!