What is a 1031 exchange and how does it work?

If you have an investment property and are considering selling it and buying another property, you need to know about the 1031 exchange. It is a process that allows the owner of an investment property to sell it and buy similar property while capital gains tax is deferred.

WHAT IS A 1031 EXCHANGE?

A 1031 exchange is the name used for the U.S. Internal Revenue Service’s tax code, Section 1031. It states that if a person trades one investment property for another through a 1031 exchange, they would be able to defer taxes or capital gains that they might have to pay at the time of sale.

Section 1031 pertains to property other than real estate; however, some 1031 cases deal with buildings and land. The Internal Revenue Service’s Section 1031 has various elements that real estate investors must know before making its use.

  • As per Section 1031, a person can only make an exchange with similar properties, and IRS has limited the rules for vacation properties only.
  • There are specific time frames and tax implications that apply and may become problematic for you.

SECTION 1031 EXPLAINED:

Taxes are only deferred on properly carried and structured 1031 exchanges, according to Section 1031. A court ruling in 1979 concluded that an agreement to exchange property within certain time limits is the same as a simultaneous property transfer. Since then, a moniker, Starker Loophole, has been attached to the law.

The tax-free exchange loophole used to be much more defined. Before Dec. 31, 2017, similar properties could have a broad range of tangible personal properties held for business purposes. For 1031 exchanges closed after Dec. 31, 2017, the only permissible property is business real estate.

KEY POINTS:

  • Section 1031 allows investors to raise cash to purchase other properties by deferring taxes on the profits of properties sold.
  • It is at times called the Starker Loophole because the sale and purchase do not need to be immediate for the tax deferral.
  • Section 1031 does not apply to or benefit owners of personal homes.

RULES FOR USING SECTION 1031:

  1. Section 1031 defers tax on exchanges of similar real estate done promptly.
  2. Property purchased with profits must be similar.
  3. Individuals must pay taxes on any “boot” in the year of the 1031 exchange. Booting is an addition of value to an exchange that is not real estate.
  4. Once a property is sold, similar real estate must be found within 45 days and acquired within 180 days.

WHY IS A 1031 EXCHANGE IMPORTANT?

It allows real estate investors to defer taxes and potentially earn wealth through property investment. For instance, if you buy a property worth $10,000 and then sell it for $50,000, you are subject to taxes on your $40,000 profit. From that $40,000, you would lose, say, $12,000 to taxes. With a 1031 exchange, you would be able to use the full amount of $50,000 to purchase another property and pay no taxes at the time of sale.

1031 exchanges are significant because they help real estate investors create more wealth. Investors can use 1031 exchanges throughout their careers to buy bigger or better properties and potentially reap the rewards

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