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10 Things To Know About 1031 Exchanges
10 Things to Know About 1031 Exchanges
You’ve probably heard of a 1031 exchange, but have you ever considered the benefits of using one to defer taxes when you sell a property? Wondering how it can help you defer taxes on your real estate investments? At the Sandy Hartmann Group, we love educating our clients on ways to save money at closing and to strategically invest in real estate. While a 1031 exchange may seem like an intimidating process, it’s actually a fairly easy and affordable way to defer taxes and often used by the savviest real estate investors.
Check out our list of 10 things everyone should know about 1031 Exchanges below:
Definition of a 1031 Exchange- When a taxpayer sells an investment property (also called the ‘Relinquished Property’) and defers capital gains taxes from the sale by using those proceeds to purchase a “Like Kind” property (aka another investment property, also called the ‘Replacement Property’). The proceeds of the sale must be held with a Qualified Intermediary in order to complete the exchange and defer taxes.
What is a Qualified Intermediary? This is the “Facilitator or Accommodator,” which is a licensed 1031 exchange firm that holds the sale proceeds from the Relinquished Property until you close on the next investment property (the ‘Replacement Property’). You need to find a Qualified Intermediary PRIOR to selling an investment property to qualify for a 1031 exchange transaction. The Qualified Intermediary not only holds the funds for you from the closing in a special account (which means you don’t have access to them), but also prepares the 1031 exchange documents for each closing. **You cannot do a 1031 exchange on a property that has already closed without a proper intermediary involved.
What is Considered a “Like Kind” property? For capital gains taxes to be fully deferred, the Replacement Property must be another investment property. For example, if you’re selling a single family home that is NOT your homestead and has been used as a rental while you’ve owned it, the proceeds from the sale of that property MUST be used to purchase another investment property in order to qualify for a 1031 exchange tax deferment. This could be industrial land, another single family home that will also be a rental, a commercial building, etc. The use doesn’t need to be exactly the same, but the property must be an investment and not your primary residence.
Do I Have to Simultaneously Sell My Property and Buy the Replacement Property? No. Once the Relinquished Property is sold (closed with transfer of title to the new owner) and the proceeds are held with a qualified intermediary (the 1031 Exchange Company you’ve selected), you have 45 DAYS TO IDENTIFY THE REPLACEMENT PROPERTY and 180 DAYS TO CLOSE ON IT. To protect yourself, it’s sometimes best to identify multiple properties in case one of them falls through while you’re trying to purchase it. Extensions are not allowed on the above timeframes unless a Presidential Disaster is declared (think hurricanes, snow storms, etc).
Do I Have to Use ALL the Proceeds from the Sale of the Relinquished Property? No. If you don’t use all the proceeds to purchase the Replacement Property, you’ll pay the applicable capital gains taxes on the leftover amount. This is called a “Partial Exchange.”
Can I Purchase Multiple Replacement Properties from the Sale of Just 1 Relinquished Property? Yes. For example, if you sell an investment (Relinquished Property) and have $200,000 of proceeds to use, you may buy two $100,000 rental homes. The rule is that you must purchase property equal to or greater in value & debt than the original proceeds.
What About Vacation Homes that I Sometimes Use for Myself? For vacation properties, these can still qualify for a 1031 Exchange when you sell them, as long as the owner doesn’t/hasn’t used it for personal use more than 14 days per year or 10% of the number of days the property was rented, whichever is greater.
Are 1031 Exchanges a Good Way to Get Out of Paying Taxes? So here’s the thing, a 1031 Exchange is a TAX DEFERRAL STRATEGY, not tax-free. It means you can basically keep reinvesting your profits from investment properties without paying taxes right away on those profits or capital gains. It’s strategic, because as your real estate investments increase in value, you can sell them at a profit and reinvest those capital gains into other income-generating properties. For instance, some investors buy vacant land, then sell it in a 1031 exchange once it appreciates in value. They use the profits from the increase in value to afford new property, like an income-generating rental property. The way you use the funds just depends on what your real estate investment goals are.
What if I Convert an Investment Property Purchased in a 1031 Exchange into my Primary Residence? So this is possible. You must own the property as an investment for at least 24 months. Then you can move in and make it your primary residence after that time. If you ever sell it, you’ll owe taxes on the sale of the property, which will be charged or prorated based on current capital gains tax laws. (It’s always best to speak with a Qualified Intermediary Firm about this to be sure there are no changes in the laws).
Can my Attorney or the Title Company Completing the Sale of my Relinquished Property Just Hold the Sale Proceeds for me Until I Find the Replacement Property? No. The Funds must be held by a Qualified Intermediary (a true 1031 Exchange Firm). According to current laws, this means that the funds cannot be held by an person who has acted as the taxpayers employee, attorney, accountant, investment banker, broker, or real estate agent within a 2 year period preceding the date of the transfer of the Relinquished Property.
For more information on participating in a 1031 Exchange Transaction, we recommend contacting a Qualified Intermediary. The information above was provided to us by IPX 1031, an Investment Property Exchange Service. See their website here for more details on the services they provide CLICK HERE.
Andrea is the Managing Partner of The Sandy Hartmann Group. She is a licensed Realtor with over 15 years of Marketing and Finance experience, holding a degree in both Finance and International Busines....
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