One of the downsides of selling an investment property is the capital gains tax that the IRS requires you to pay. But the IRS also provides you with an out know as the 1031 exchange. This method allows you to defer capital gains tax liability when selling an investment property by purchasing another like-kind property with the profit gained by the sale of the first.
There are guidelines that must be followed and conditions that must be met in order to qualify, and that process starts with filling out the necessary paperwork providing information about the properties you’re looking to sell or relinquish. You must also identify three properties you are looking to purchase and then close on one of those three.
There are four types of 1031 programs.
A simultaneous exchange occurs when the property you are purchasing and the property you are selling close on the same day. There are three ways this can occur. The first involves the two parties exchanging or “swapping” deeds. The second involves a third “accommodating party” that facilitates the simultaneous transaction. The third makes use of a qualified intermediary who structures the entire exchange.
The delayed exchange is the most common type. This one occurs when the person sells the original property before he acquires a new replacement property. For this approach, you must hire a third party exchange mediator. This person can hold the funds for up to 180 days to give you time to locate a replacement property. You must identify the replacement property within 45 days.
A reverse exchange, also known as a forward exchange, occurs when you purchase a new property before selling your old property. This one requires you to make the purchase in cash, and most lenders will not approve a mortgage under these conditions. You have 45 days to inform the IRS that you’re taking this approach, and then 135 days to complete the process in total.
The construction exchange allows you to use tax-deferred dollars to make improvements on the new property. The property must be placed in the hands of a 1031 mediator for a 180-day period for this one. All of the funds must be used toward improvements and you must receive “substantially the same property” that you identified within 45 days. Along with that, the new property must have an equal or higher value when it is deeded back to the owner. The improvements to the property must be completed before the property is deeded back.
1031 exchanges are a great way to gain capital to your portfolios and defer taxes to a later date. As always surrounds yourself with the right team of individuals to guide you through the process successfully. That team should include a real estate broker skilled in 1031 exchanges, an attorney, and an accountant.
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