As a landlord, it’s important to take advantage of any money and tax saving options you have available to you. One benefit you may find useful is the 1031 exchange, which can help you defer taxes. The more you know about the 1031 exchange entails, the better you’ll understand if this tax deferral is something you can take advantage of.
What Is a 1031 Exchange?
A 1031 exchange is a tax-payer tool that is used to swap one investment for a similar one and defer paying capital gains taxes. A 1031 exchange allows taxpayers to have limited taxes or no tax dues at all when the exchange is occurring, so long as the swap meets the 1031 requirements.
This exchange is beneficial regarding tax, investments, and estate planning. In terms of investments, a 1031 exchange can help you avoid capital gains throughout your life so long as you follow the mandated regulations.
Qualifications
To do a 1031 exchange, the investment needs to be a real estate property that’s held for investment or business use. Your personal residence would not qualify. If you live in your vacation or second home, these wouldn’t qualify either. It’s important to consult a tax expert to determine their usage given the usage test listed in the tax code. Developing land or resale property purchases do not qualify either.
When to Do a 1031 Exchange
Use a 1031 exchange when you want to sell a business or investment property for gain and avoid paying taxes on it. Here are some circumstances where you can use this exchange:
- When you own a rental property that’s worth more than the initial purchase price
- When you want to diversify your assets
- When you want a managed property rather than one you’d have to manage yourself
- When you want to consolidate properties into one
- When you want to divide one property into several assets
- When you want to avoid an increase in taxable income from depreciation recapture
How to Do a 1031 Exchange
Follow these steps to successfully perform a 1031 exchange:
1. List Your Property for Sale
After determining you want to perform a 1031 exchange, you need to list your property for sale. It’s important that the buyer of your property understands your desire to do a 1031 exchange.
2. Find a Replacement Property
Once your property sells, you have 45 days to identify a new property. Begin your search for a like-kind property as soon as possible to ensure you meet the deadline.
3. Find an Intermediary
Next, you need to find a qualified intermediary to handle consultations with the title company and other work. This can be an independent third party. The intermediary should not have any relation to you.
4. Accept an Offer On the Property
Prior to accepting an offer, ensure the purchaser of your property knows that you’re doing a 1031 exchange. They must also comply with the terms of the 1031 exchange by signing off on certain paperwork. Once you’ve found a buyer that will comply, you can accept an offer on the property.
5. Close the Sale of the Property You’re Selling
The title company or attorney and your intermediary will handle the closing process. Once the sale is complete, the money will go to their account rather than yours since you cannot have possession of it during this step.
6. Identify the New Property
Next, you need to identify the new property. You have 45 days from your old property’s sale to do this. You can identify up to three properties.
7. Sign a Contract
Once you’ve selected the property or properties you want to purchase, get it under contract and open escrow. The seller of the property you’re purchasing needs to know that you’re doing a 1031 exchange. If you choose to, you can also go under contract on three properties and back out on the ones you’re no longer interested in later on. This would use the contingency clause.
8. Allow Your Intermediary to Consult With the Title Company
During this step, you, your intermediary, and your agent will ensure all paperwork is complete. This is an important step in the 1031 exchange process as the swap nears completion.
9. Close On the Replacement Property
During this final step, the intermediary sends your money to the title company or attorney. The sale closes and taxes do not need to be paid.
1031 Exchange Rules
The 1031 exchange does not impose a limit on how many times a taxpayer can use it, though there are regulations you need to meet to take advantage of the tax deferment. Here are the rules and regulations you need to follow:
- Time: You have 45 days to identify a new property, starting the day of the existing property’s sale. This is the identification period. In addition, you need to complete the exchange no later than 180 days after the exchanged property’s sale. This is the exchange period.
- Title: The taxpayer listed on the old property and new property needs to be the same.
- Intermediary: The 1031 exchange does not allow sellers to have access to the money during the sale. A qualified intermediary such as an independent third party needs access instead.
- Ownership timeline: Both the property you are selling and the property you are buying cannot be under your ownership during the same time.
- Reinvestment: Rather than reinvesting 100% of the proceeds into another property, you can perform a partial exchange. You also have the option to have multiple replacement properties.
- Like-kind property: To comply with a 1031 exchange, the two properties — the one you’re selling and the one you’re purchasing — need to be similar.
If you own a property that is worth more than what you paid for, consider using a 1031 exchange. This tax deferral tool can help you save a substantial amount of money on taxes that you would have otherwise had to pay.
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