If you are into real estate property investments, then there is a great chance that you are already aware of the 1031 tax-deferred exchange. Through this exchange, you will be able to sell properties while deferring capital gains tax. This article focuses on what the 1031 exchange is all about and how it works.
1031 Exchange in Brief
1031 exchange obtained its name from Section 1031 of the US Internal Revenue Code. This section indicates the details that you need to know to avoid paying capital gains taxes when you sell an investment property for as long as you will reinvest the proceeds from the sale within a certain time frame. Nevertheless, the proceeds you receive from the sale are still taxable. However, you can choose to transfer the proceeds from the sale to a qualified intermediary. A qualified intermediary will facilitate the 1031 exchange by holding the funds until these can be transferred to the seller of the replacement property. Just keep in mind that the qualified intermediary should have no formal relationship with any of the parties involved in exchanging the property.
Apart from the 1031 exchange, you can also explore alternatives that can help you diversify your assets. In this case, there is the option for you to look into the 721 exchange, which is a 1031 exchange alternative that is also widely used in the real estate industry. Apart from a similar tax-deferred benefit as the 1031 exchange, you will also get the bonus of liquidity with the 721 exchange. Thereby, many real estate investors prefer the 721 exchange over the 1031 exchange.
There is a broad range of exchangeable real estate properties under the definition of like-kind property. For example, a vacant lot can be exchanged for a commercial building because the properties can be categorized as like-kind. However, you cannot exchange real estate for artwork for instance because they do not meet the definition of like-kind. The property must also be held for investment and not for resale or personal use.
There are three common types of like-kind exchanges namely the delayed exchanges, build-to-suit exchanges, as well as reverse exchanges. A delayed exchange is a 1031 exchange carried out within 180 days. On the other hand, a build-to-suit exchange allows the replacement property to be renovated or newly constructed, subject to the 180-day timeline rule. This means that all the improvements or construction that needs to be done in the property must be completed before this time frame lapses.
Finally, a reverse exchange is one when you acquire the replacement property before selling the property to be exchanged. For a reverse exchange, however, you need to transfer the property to an exchange accommodation titleholder, which can also be the qualified intermediary. In the same manner, as with the other types of like-kind exchanges, all transactions must be carried out within 180 days.
Reasons to Leverage the 1031 Exchange
There are various reasons why you may want to delve into the 1031 exchange apart from avoiding capital gains tax. For instance, you may be seeking a property that has better return prospects or you may be looking into diversifying your assets. In this case, the 1031 exchange can work perfectly for you.
On the other hand, if you are the owner of an investment real estate, then you may opt for a managed property already instead of looking into managing one yourself. There is a great chance for you to come across the former using the 1031 exchange. In the same manner, in case you want to consolidate your properties into a single property that you can easily manage for estate planning, or you may want to divide a single property into several assets, then the use of 1031 exchange may also work for you.
1031 exchange proves to have various benefits although the most common one is tax deferral. With the use of this platform, not only will you be able to avoid paying capital gains tax, but you will also have the opportunity to diversify your assets. Rest assured that there are 1031 exchange alternatives that you can explore should you deem that you will be able to get more if you opt for the latter.
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