In simple terms, a 1031 exchange is a trade of one investment property for another that allows you to defer capital gains taxes. While potential tax reform could impact 1031 exchanges, we wanted to walk through what they can do for you today. This powerful tax strategy must be used carefully as there many moving parts, some of which are time sensitive, that must be met before you can start.
Let’s walk through some of the basics on the 1031 exchange.
What are capital gains taxes?
Capital gains taxes apply to profits made from the sale of an asset, which in this case, would be your property.
What is a 1031 exchange Qualified Intermediary?
In most cases, a 1031 exchange will be considered a “delayed exchange” as most people need time to find a suitable replacement property to invest in. If you do use a delayed exchange, you will need to partner with a Qualified Intermediary to handle your transaction.
This person, also known as an accommodator, facilitator, intermediary, or QI, facilitates the following:
- Documents the exchange by preparing the necessary paperwork (Exchange Agreement and other documents).
- Holds proceeds on behalf of the Exchanger.
- Structures the sale of the relinquished property and purchase of the replacement property.
We offer this service through Asset Preservation Inc. If you would like to learn more, visit API Exchange.
What are the 45-day and 180-day rules?
1031 exchanges are very time sensitive. There are two timelines you must keep track of while doing an exchange: a 45-day mark and 180-day mark.
- The 45-day rule has to do with designating your replacement property. When you close on the original property you sold, you have 45 days to announce in writing what your replacement property will be.
- The 180-day rule has to do with the closing on your replacement property. The IRS allows up to 180 days between the sale of the original property and the purchase of the replacement property.
- Note, both these timelines are running simultaneously. So, once the 45-day mark passes, you have 135 days to complete the process.
What is the “like-kind” rule?
Both the “original” and “replacement” properties must be held for investment or used in a business. The IRS uses the term “like-kind” to describe the type of properties that qualify. In simple terms, both the properties you sell, and purchase must be used for investment purposes. They don’t have to have identical functions, like residential property vs. commercial property, however they must both be “held for investment.”
Properties which are clearly not “like-kind” are an investor’s primary residence or property “held for sale.”
Note: To defer all capital gain taxes, you must buy a replacement property or properties of equal or greater value (net of closing costs), reinvesting all net proceeds from the sale of the original property. Any funds not reinvested are taxable.
When are capital gain taxes paid?
Maybe never. Many investors mistakenly believe they will have to pay the taxes sometime so they might as well just sell. Quite often, this is a bad investment decision. The tax on an exchange is deferred into the future and is only recognized when an investor sells the property for cash instead of performing an exchange. Under current tax law, investors can continue to exchange properties as often and for as long as they wish, thus moving up to better investments and putting off the taxes for many years.
This information is provided for general informational purposes only, should not be solely relied upon and is subject to change without notice.