If you plan to sell an investment or business property, paying tax bills from the substantial profit is a critical concern. The good news is that investors can seek the advantages of a tax deferral program that enables them to defer payment of capital gains on property sales. In some cases, investors can avoid paying the tax on capital gains. It is possible with a like-kind exchange, also called a 1031 tax deferred exchange. Section 1031 of the IRS (Internal Revenue Code) allows investors to replace one real estate property with a like-kind property without paying taxes.
Eligible Properties
A key factor influencing the 1031 Exchange is the transactions occurring in exchange with like-kind properties, rather than selling one property and replacing it with another. There is no need to deal with identical properties. The relinquished property and the new or replacement property should belong to the investment or business real estate grade. Further, the properties should be within the US territory to qualify for the 1031 Exchange. Some examples of like-kind exchange properties include:
- Shopping centers for barren land
- Apartment buildings for industrial buildings
- Offices for shopping centers
- Raw land for strip malls
Real estate investors should note that personal use properties like vacation homes and primary residences don’t qualify for 1031 Exchange. The under-development land for resale is not eligible for the like-kind exchange. Financial instruments and securities, like bonds, stocks, and partnership interests, don’t qualify for the 1031 tax deferred exchange.
To use the 1031 Exchange, investors must complete IRS (Internal Revenue Service) Form 8824 and attach it to their annual tax returns. They should be cautious of the conditions that allow them to use the like-kind exchange on vacation homes and principal residences. Investors might rent the property for a specific time and limit the time of their personal use/stay.
Particular Rules and Timeline
Real estate investors should monitor the calendar to execute the 1031 Exchange. Identifying and closing on the replacement property within strict timelines is sometimes challenging. The first task is to find one or a couple of replacement properties within 45 days from the date of property sale. The replacement property should equal or exceed the original or old property. Investors can purchase a maximum of three properties without concern about the fair market value or number of properties as long as the average value doesn’t overpass 200% of the old property’s sale price. In addition, the replacement property should be owned within 180 days of the sale date.
It is essential to stick with the timeline and leverage the maximum tax benefits for the 1031 Exchange. Investors should take on equal debt for the new property if it is financed or mortgaged. Complying with the timelines and requirements is a must to avoid challenges and complexes and seek the advantages of the 1031 tax-deferred exchange.
Using a QI (Qualified Intermediary)
To leverage the advantages of the 1031 Exchange, investors should pick a QI (Qualified Intermediary), like an accountant, real estate lawyer, or a title company that holds the property sale funds in escrow funds. If investors take out the funds before the like-kind exchange is complete, they are liable to pay tax bills and are not eligible for the 1031 tax-deferral exchange.
A Qualified Intermediary is a custodian who holds the sale proceeds from the old property and utilizes them to grab the replacement or new property, eliminating the investors from using the funds. Through the FEA (Federation of Exchange Accommodators) investors identify state-wise QIs or Qualified Intermediaries. Real estate investors should be careful with specific conditions and regulations when using the 1031 Exchange on vacation and principal or primary homes.
To seek tax-deferral benefits, investors should rent the property for a timeframe and calculate the years they stay.
Conclusion
To reap the advantages of the 1031 tax-deferred exchange, real estate investors should consider the eligibility factors and abide by the strict requirements and timelines. Furthermore, using a QI or a Qualified Intermediary is critical for successful like-kind exchanges. The 1031 Exchange is an excellent tool for real estate investors who want to avoid paying taxes, maximize profit, and expand their portfolios.
