When you sell an investment property at a profit, you typically have to pay taxes of up to 20-35% (depending on what state you live) on that profit.
But with the 1031 exchange you can take all of those taxes you would have paid, and invest them in another property…amazing!
How does it work? Here’s everything you need to know about the 1031 tax exchange, from an easy to understand the definition, to the timeline, to how you can use it too.
What Is the 1031 Exchange?
The 1031 exchange is a tax deferment, and it needs to be a part of your real estate investment strategy.
It allows you to roll your profits from one investment property into the purchase of another like property. You save money because if you follow the rules, you won’t have to pay any taxes on the profit.
It’s important to note that your taxes are deferred, the way they are in many retirement accounts, not completely wiped out.
A 1031 exchange is a complicated process, even for professionals. So it’s important if you ever want to take advantage of this, get a professional on your side.
What Is “Like Property”
One big part of the 1031 exchange is you need to “exchange” an existing property for a “like” property. In its original conception, the 1031 exchange applied when one property was directly swapped for another.
That still applies today as one of the four different kinds of like property.
The first kind is a simultaneous exchange. This occurs when you exchange one property directly for another. This occurs when the relinquished property and the new property close on the same day.
But the timing has to be very exact for you to use a 1031 exchange. Because of this, it most often happens with a direct deed swap. But it’s also possible to do a three-party exchange with a compliant third party or to work through an intermediary.
The second type of like property is called a delayed exchange. Since this type of exchange gives you more time and has more flexibility, it’s the most common type of 1031 exchange people use.
Even still, you do have a time constraint. You have 45 days to find a new property to invest in, and 180 to close the deal before you’ll owe taxes on the profit of your sale.
With a reverse exchange, you buy your new property before relinquishing your previous investment property. However, you need cash for the whole deal.
You have 45 days to decide which property you’re going to sell, and you have 135 days to sell it.
Construction or Improvement Exchange
The last option is the construction or improvement exchange. With this type of 1099 exchange, you use the profits from your last investment property to make improvements to a new one.
But like with the other types of 1031 exchanges, you still have time requirements you need to follow. You have 180 days to spend the exchange equity on down payments or completed payments for improvements on the new property.
You have 45 days to exchange “substantially the same property” identified by the taxpayer.
And finally, the replacement property must be of equal or greater value when deeded back to the taxpayer.
What Is the 1031 Exchange Timeline?
As you can see, the type of property you invest in will affect the timeline you have to abide by. But no matter what type of 1031 exchange you’re using, circle day 45 and day 180 as ones to remember, because that’s when your deadlines are due.
Typically, the 45-day mark is when you need to designate replacement property. If you don’t have a replacement property lined up by day 45, you’ll lose your 1031 exchange, and have to pay capital gains taxes on your profit.
The 180-day mark is when you need to close the deal. Again, if you miss this mark, you’ll lose the 1031 exchange and owe taxes.
What Are the 1031 Exchange Rules?
Just like there’s an important timeline you need to follow, you need to carefully follow rules too. Generally, 1031 exchange rules apply no matter what state you’re in, but it’s always best to have an expert on your side. Screwing up the process will cost you thousands of dollars.
So what rules do you have to follow? There are seven of them.
- Like-Kind property
- Investment or business purposes only
- Greater or equal value
- Must not receive “boot”
- Same taxpayer
- 45-day identification window
- 180-day purchase window
Above we covered the different types of like-kind property and the importance of the 45-day and 180-day windows.
1031 exchanges apply only to investment or business properties. You cannot apply them to a residential property.
For a 1031 exchange to apply, you have to use it when exchanging property for one of equal or greater value. Otherwise, there would be little point, since you wouldn’t owe taxes on it.
The boot is when your investment property creates revenue during the 1031 exchange, and it will be taxed as capital gains. Therefore, for your 1031 exchange to completely tax-deferred, you can’t receive boot during that time.
The same taxpayer rule simply means that the same taxpayer has to have their name on the old deed, and on the new one.
The 1031 Exchange Is the Secret Tool You Can’t Afford to Use
When you understand how to use a 1031 exchange, it will save you tens of thousands of dollars. You can use this valuable tool anytime you sell an investment property to roll over the sale into a new investment piece, without paying taxes.
Understanding the rules and timeline is vital to properly use this tool. But once you understand the basics, it’s easy to implement.
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