What does it mean to do a 1031 exchange?
A 1031 exchange is a type of tax-deferral strategy that allows real estate investors to swap one investment property for another, without paying taxes on the proceeds. This is a popular option for savvy investors, but it’s not as simple as it sounds.
Oftentimes, there are many moving parts to this complex process, and it’s important to have a professional handle the transaction on your behalf. In order to ensure the exchange goes as smoothly as possible, it’s best to work with a qualified intermediary, which is typically a broker or real estate agent that is experienced in this specific type of transaction.
The IRS has rules that define what kinds of properties can be used in a 1031 exchange. In general, a property must be “like-kind,” which means that it must be identical in all respects and of equal value.
If you own an investment property and want to use it for business purposes, a like-kind exchange can help reduce your tax bill by avoiding capital gains taxes. In order to qualify for this strategy, you must sell an investment property and purchase a replacement property that’s also like-kind.
There are some exceptions to the rule though, so it’s a good idea to consult with a tax expert before you start planning a 1031 exchange.
To avoid paying taxes on the money you receive from selling your investment property, the funds you receive must stay in escrow until you buy the new property. You cannot take the money out of escrow or receive it for any other purpose during the exchange.
In addition, you must meet a few other requirements to do a successful 1031 exchange. For starters, you must reinvest all of the equity in your original investment property into your replacement property. Then, the purchase price of the replacement property must match or exceed the sale price of your original investment property. Finally, you must put on debt that is equal to or greater than the amount paid off on your original investment property.
You’re allowed to identify up to three replacement properties during the initial 45-day exchange period. This rule is known as the “3-property rule” and can make a big difference in how smoothly a 1031 exchange runs.
A qualified intermediary is an expert in a variety of different areas of real estate and can be a valuable asset during a 1031 exchange. They are able to help structure the exchange, coordinate the sale of your old property and the purchase of the new property, and prepare the necessary documentation.
They can also help with the financing portion of your exchange. For example, if you have a loan on your original property that you’d like to use in the new property, a qualified intermediary can help with a note buyout to substitute that financing for personal cash or a loan from the buyer of the new property.