Basics of 1031 Exchanges, and How They Can Help You Avoid Capital Gains Taxes
By Rachel Puryear
If you have owned an investment property for a long time, and it has appreciated a great deal in value over the years, you might be concerned about paying a large capital gains tax bill if you sell it. Accordingly, you might have wanted to trade the property in and buy a different one instead, but are reluctant to do so because of tax consequences. A 1031 exchange might be a good solution for you, in this scenario.
Basically, a 1031 exchange works like this: You relinquish one investment property, and the proceeds are used to buy another property instead. All of this goes through an exchange facilitator. In order to get the capital gains tax break from the IRS, a very technical set of rules must be followed correctly – the exchange facilitator helps to ensure that happens.
Note: It’s called a “1031 exchange”, because Section 1031 of the Internal Revenue Code governs such transactions.
The main requirements for a successful 1031 exchange are as follows:
- The title holder of the properties exchanged, and the taxpayer, must be the same person. One cannot do such an exchange to benefit a different taxpayer other than themselves.
- The properties exchanged must be “like-kind”. However, what is considered “like-kind” is quite broad. For instance; a single-family home could be exchanged for a duplex or condo, and vice-versa. A single property could be exchanged for multiple properties, and vice-versa. All properties involved in the exchange must be located within the United States.
- Both the relinquished property and the newly acquired replacement property must be used as investment properties. 1031 exchanges may not be used for primary residences.
- The taxpayer making the exchange must identify a replacement property within 45 days. This does not completing the purchase 45 days – just identifying the new property. However, the taxpayer must also complete the purchase within 180 days. The 180 day limit includes the initial 45 days, and is not given in addition.
- The taxpayer must roll all of the proceeds from the relinquished property into the replacement property. The taxpayer may not receive any proceeds from the transactions, and the funds must go through the exchange coordinator instead. If excess proceeds are left over because the replacement property costs less than the relinquished property, then the taxpayer must pay capital gains taxes on that excess. The excess is known as the “boot”.
- The most common type of 1031 exchange is a delayed exchange. In this type of transaction; the taxpayer sells their relinquished property, the proceeds go into a special trust managed by the exchange coordinator, and then the taxpayer buys the replacement property.
If you would like to sell one investment property and acquire a different one, for whatever reason, and avoid paying a large capital gains tax bill; a 1031 exchange could be a great solution to your situation. If you need a licensed realtor to help you with this, please reach out to me here to get in touch.
Thank you, dear readers, for reading, following, and sharing. Here’s to successful exchanges, and minimizing your tax bill while doing so.
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