Most of us may encounter the term “1031 exchange” when mentioned by real estate agents, investors and title companies. But what exactly is it and what do you need to know before going through it?
What is a 1031 exchange?
One of the ways property investors can earn money is by selling property, the gains from which are subject to taxation. However, there is a loophole defined in Section 1031 of the IRS code that property investors may utilize to lessen their tax burden when selling an investment property. This loophole is known as the 1031 exchange.
What does a 1031 exchange do?
Basically, a 1031 exchange allows a property investor to replace one property with another when they sell it. As property investor, the gains you had from selling the original property goes into the purchase of the new property. And, since you are using the gains to buy another property, you would not be required to immediately pay taxes on the money you supposedly gained. You will only need to pay taxes when you sell the new property, unless you secure another 1031 exchange.
How does one qualify for a 1031 exchange?
There are three criteria that you must meet in order to qualify for a 1031 exchange:
First, the investment property you are about to purchase needs to have a value that is equal or greater than that of the property you are selling;
Next is that you have to use all the gains from selling the previous property to purchase the replacement property.
Lastly, the new property should be a “like-kind” investment.
A like-kind investment or property only means that your replacement property should be a similar kind of investment, and you are purchasing the replacement property only as an investment and not for personal use. The like-kind property may not necessarily be the very same type of property either. If you are selling a residential real estate property, for example, you can buy any other type of real estate — like a plot of land or a retail property — as long as it is considered an investment.
What are the benefits of a 1031 exchange?
A 1031 exchange could make it easier and a lot cheaper for you to get rid of a property you no longer want and buy another to replace it. Otherwise, you will need to pay thousands of dollars for taxes on the sale of your original property, which could have gone to the purchase of your new property.
Property investors may also use a 1031 to sell one high-value property and use the gains to buy multiple properties that could yield higher returns. A 1031 exchange can be repeated several times as well, enabling you to defer taxes indefinitely, and, upon your death, the assets you bought using 1031 exchange can be passed on to your heirs tax-free.
You will need a lot of help when doing a 1031 exchange. According to IRS regulations, there has to be a qualified intermediary to hold the gains from the sales of the original property until you use it to purchase the replacement property. You might also need 1031 exchange services for expert advice on how to maximize the benefits of this exchange.