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Through the use of a 1031 exchange, you can sell an investment property and buy another without realizing capital gains taxes – if you do it right.Need a pre-approval for the new property? Start here.
A 1031 exchange is a term derived from Section 1031 of the U.S. Internal Revenue Code. It permits taxpayers to postpone acknowledging capital gains and federal income tax obligations on specific property categories.
The first thing you need to know is that all 1031 exchanges must be filed through the IRS. There are two deadlines that govern the exchange process:
- The identification of a replacement property in writing within 45 days
- The acquisition of a new property within 180 days
Note: if you’re unable to complete the exchange within your tax deadline, you may be able to file for an extension.
The 1031 exchange timeline consists of seven steps:
- Identify the property you want to sell
- Identify the property you want to purchase
- Choose a qualified intermediary (QI)
- Calculate how much of the sale proceeds from your current property will go toward your new property
- Plan your transaction to fit within the timeline requirements
- Report your transaction to the IRS
- Utilize the remaining proceeds from the sale to avoid capital gains taxes
A thorough understanding of these steps and how they apply to your situation allows you to maintain compliance with all timeline requirements.
As noted above, there are two specific rules you must follow to meet the timeline:
- 45-day identification period: You have 45 days from the sale date to identify a suitable replacement property. This is referred to as the 45-day identification period as a taxpayer.
- 180-day rule: You must purchase a replacement property within 180 days of the sale (closing date) of your original property.
Every decision you make with a 1031 exchange should be based on meeting these two deadlines.Make sure you’re approved for the new purchase.
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The advantages of a 1031 exchange run deep, starting with the opportunity to avoid capital gains taxes.
A 1031 exchange allows you to defer paying capital gains taxes on the sale of an investment property if you reinvest the proceeds in like-kind property. This means you can keep more of your profits working for you, and delay paying taxes until you sell the replacement property.
Deferring taxes gives you more money to reinvest in your new property. This can increase your purchasing power, allowing you to acquire a higher-value property or a portfolio of properties that better align with your finances and investment goals.
For some investors, a 1031 exchange is a path toward greater diversification. For example, you may be able to exchange a single-family rental property for a commercial property or a multi-family building.
Through a 1031 exchange, you may be able to gain access to all the cash you need upfront. You can then take advantage of a cash-out refinance or home equity loan in the future should it be necessary.
Even if you have the best intentions of meeting the 1031 exchange timeline, you never know what could get in the way.
The three deadlines you must meet include:
- 45-day identification period
- 180-day exchange period
- The replacement property received deadline
Understanding these deadlines and planning accordingly is crucial since failing to meet any one of them will invalidate your 1031 exchange. Should that happen, you’re then obligated to pay capital gains taxes on the sale of your property.
Before attempting a 1031 exchange, it’s good practice to review some example scenarios to better understand how it’ll impact you.
Let’s start with the basics. Suppose you have a property that you want to sell with a $200,000 mortgage balance. It sells for $500,000.
If you want to take advantage of a 1031 exchange, you must purchase a replacement property for a minimum of $500,000. Additionally, you’re required to borrow a minimum of $200,000 to pay for it.
In short, you have to use the same former loan balance and equity for the new property.
But what if you can’t find a replacement for the same amount as your original property? This is actually very common, and even desired, so you can upgrade your investment portfolio with bigger properties.
During your search, you find a property that you want to purchase for $600,000. In this situation, you can use:
- A $200,000 loan (same as the previous property)
- $300,000 sale proceeds
- $100,000 additional cash
This allows you to meet all requirements for deferring taxes.
You don’t want to sell a property just to find out that you’re not approved to buy another. This will force you to pay capital gains tax because you can’t fulfill the 1031 requirements.
Get a pre-approval for the type and price of property you’d like to buy next. Then, there will be few surprises, if any, when you make an offer and close on the next property.Get a loan pre-approval in as little as one day here.
It’s clear that you can exchange one type of property for the same time, such as two single-family homes. However, you may have questions about exchanging one type of property for another type.
Here’s what the IRS has to say:
Both properties must be similar enough to qualify as “like-kind.” Like-kind property is property of the same nature, character, or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land…Improvements that are conveyed without land are not of like kind to land.
Most real estate is considered “like-kind.” For example, the following property types could qualify as like-kind:
- Apartment buildings
- Office buildings
- Raw land
- Retail properties
- Industrial properties
- Residential investment properties
While most types of properties can be exchanged, it’s critical to be 100 percent certain before taking action.
There are four general types of 1031 exchanges:
- Delayed exchange: The most common type of exchange, this is when you sell a property you own and direct the proceeds to a new purchase.
- Reverse exchange: This occurs if you find a property you want to purchase before deciding to sell a property that you own.
- Simultaneous exchange: A same-day buy and sell of two properties.
- Improvement exchange: It’s used if you need to improve your new property before taking possession.
Knowing what type of exchange you’re using will help you meet all deadlines.
With proper planning and execution, a 1031 exchange can provide significant advantages and help you achieve your long-term financial and investing goals. As such, it’s a tool that you should strongly consider using when applicable.Start your pre-approval so you’re ready for your 1031 exchange.
My Perfect Mortgage does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. Consult advisors before filing taxes or engaging in any transaction.
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