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1031 Exchange: What Is It?

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In keeping with our discussion on real estate investing, there is a powerful tool available to taxpayers called the 1031 Exchange that allows a person to sell an income, investment or business property, and replace it with a “like-kind” property while the capital gains on the sale of the original property are deferred.  Essentially, the profit made on the sale of the original property will not be hit with the capital gains tax which can run as high as 15 to 20% between state and federal taxes combined.

In effect, one can change the form of your investment without cashing out or recognizing a capital gain.  The investment can in theory continue to grow tax deferred in perpetuity, as long as you follow the stringent rules as specified in the tax code.  There’s no limit to how many times you can roll your investment via the 1031 exchange.  But the tax code is tricky and difficult to navigate, and there are specific stipulations and time constraints that must be adhered to.  Here are a few basic tenets of a 1031 Exchange:

1)   A 1031 is not for personal use.

The 1031 provision is written for investment and business properties only, so one may not swap a primary residence for another.

2)  “Like-kind” is a broad term.

Most exchanges must merely be “like-kind,” which is a fairly liberal term.  You can exchange a house for an apartment building, a building for land, a land for a strip mall, etc.

3)  You can “delay” an exchange.

An exchange in theory is a simplae swap of one property for another between two people, but the likelihood of finding someone with the exact property you want and wants your property in exchange is slim.  For that reason, most exchanges are “delayed,” and have an intermediary party that holds the cash after the sale of your property and uses the funds to buy the replacement property.

4)  You must designate a replacement property. 

Once the sale of your property occurs, you have 45 days to designate replacement property to the intermediary, specifying the property you want to acquire.

5)  You can designate multiple replacement properties.

The IRS states that you can designate up to 3 properties as the replacement property as long as you eventually close on one of them.

6)  You must close within 6 months.

You must close on the new property within 180 days of the sale of the original property.  The clock starts to tick the day your original property is sold.  If you take 45 days to designate a replacement property, then you have 135 days from that point forward to close.

7)  If you receive any cash, it will be taxed.

If there’s cash leftover after the intermediary acquires the replacement property, it will be returned to you at the end of the 180 days and that cash, also know as the “boot,” will be taxed as a capital gain.

A 1031 Exchange is a great tool for real estate investing and building wealth over time.  But there are a lot of exclusions and time constraints involved with successfully executing a 1031 exchange.  Employ a trusted real estate advisor like a realtor before you embark on an exchange.  A realtor should have valuable insights on how exchanges work and help you buy and sell the properties for the swap.  Furthermore, they should be able to refer you to a trusted intermediary who will be the foremost expert on the tax code and instrumental towards facilitating the transaction to an effective close.