Are you planning to sell a property but the thought of paying capital gain taxes is bothering you? Or do you want to know the latest updates of 1031 Exchange and 1031 Exchange Rules 2019? Stop worrying now; I will teach you all these with 9 bullets.
What you’ll learn:
- What is the 1031 Exchange Rule (Background and Principle)
- Types of 1031 Exchange (4 Common Types)
- What are the 1031 Exchange Rules (7 SECRETS Revealed)
- Why is the 1031 Exchange Important?
- The Process of the 1031 Exchange
- Who Will Hold the Money During the 1031 Exchange Process?
- How Many Times are Investors Allowed to do a 1031 Exchange?
- Three Property Rules that Must be Remembered
- Risks of 1031 Exchange
Let’s start the ball rolling now…
1. What is the 1031 Exchange (Background and Principle)
The 1031 Exchange Rule operates under the provisions of section 1031 of the Internal Revenue Code. This procedure is also known as Starker Exchange or Like-Kind Exchange that is used by financial investors to skip from capital gain taxes.
When you adhere to this rule, investing or swapping of one business to another is completely non-taxable.
There are several reasons why an individual may utilize the 1031 Exchange. Some of them are listed below:
- You own a real estate investment and consider looking for a managed property to run.
- You plan to diversify your assets and want to procure a property with a good return prospect.
- You want to divide property and generate multiple assets or want to combine several properties into a single domain.
- You may also avail this rule if you wish to reset the depreciation clock.
2. Types of 1031 Exchange (4 Common Types)
This is the most common type of 1031 Exchange. Under the Delayed Exchange, the investor is given a 180- day leeway [after selling the relinquished property] to determine a new property or a replacement property that the investor intends to buy.
This is considered as the oldest method of employing the 1031 tax-deferred exchange.
3 Ways of Performing Simultaneous Exchange
Three- Party Exchange:
There’s a need for an ‘accommodating party’ to carry out this kind of exchange. The ‘accommodating party’ facilitates the transaction of the taxpayer. This procedure has two formats: Baird and Alderson.
Under the Baird Format, the title is directly pass through the Seller, while in the Alderson Format, the title is transferred through the intended Buyer.
Two- Party Trade or Swap:
This occurs when two parties swap or exchange deeds with each other. Swapping is deemed better than the other simultaneous exchange procedures since there’s no need for a qualified intermediary. However, it is difficult to find a party that is willing to acquire your property the way you would want to take over the other’s property.
Simultaneous Exchange With QI:
If you want a Qualified Intermediary (QI) to do the task of preparing the exchange agreement and other documents, as well as providing written Instructions to the closing officers, this procedure is best for you. When you utilized this procedure, you are assured that you are at the ‘safe harbor’ since the Treasury Regulations of 1991 assured that only the reliable entities are permitted to enjoy the services of a QI.
This is also called as Title- Holding Exchange wherein it requires the purchased of the Replacement Property and closed the transaction before the Exchange Property is sold.
3. What are the 1031 Exchange Rules (7 SECRETS Revealed)
Rule 1: Same-Nature Property
In the world of investing, it is possible to exchange one property to another as long as they are assets of the same nature. This means that it is possible to exchange a house with a farm lot. It is also allowed to exchange multiple properties into one large property or the other way around. The exchange is valid as long as the new properties are like the original property that you had.
Rule 2: Business Property
The 1031 rule only applies to assets that are for investment or business. This means that you cannot exchange a primary residence you have in one city with another in a different city.
Rule 3: Value
When using the 1031 rule, it is important that the property that will be exchanged with is of the same value or higher. If the replacement property is of less value, 100% of the tax will not be deferred.
Rule 4: The 45-day rule
Within the 45-day period, a replacement property must be identified. It is possible to identify three properties and only buy one. However, if you are going to identify more than three properties, it must not exceed 200% of the total value of the property you are going to relinquish. If the value increases 200%, you will have to buy 95% of the identified properties.
Rule 5: The 180-day rule
The replacement property must be settled within 180 days. The replacement property is the property that will be exchanged with the one you are selling.
Rule 6: Debt Trading
There are times wherein the property that will be traded will have debt. If the properties being exchanged have debt, even if the new property being used to replace the property being relinquished is of higher value, it is important to calculate the debt difference.
If the debt difference is, for example, $200,000, then it is possible to just add this amount to the deal in order to prevent being taxed.
Rule 7: Tax Payer Name
The name that appears on the tax return and the title of the relinquished property should be the same name found in the tax return and the title of the new property.
If you want to know which exchange rule suits for you, further read this article.
4. Why is the 1031 Exchange Important?
The 1031 exchange is important because the price of real estate has already surpassed the “bubble level” which had happened a decade ago. As any good investor would understand, this is the right time to buy and sell properties in the market for cash flow opportunities.
As an investor, there are other numerous reasons why you should be aware of the 1031 Exchange rule. These reasons include searching for a managed property, looking for a property with better profit gains, merging multiple properties into one, saving an asset that has depreciated, or diversifying assets.
5. The Process of the 1031 Exchange
The first step is to identify the properties and see if it will be a good thing to use the 1031 exchange rule.
Calculate your gains in order to decrease the chances of losing money in your deal.
The second step is to look for a qualified intermediary that will be able to help you with the 1031 exchange. The amount that is paid to them is usually around $800 to $1000.
The third step is to put your property on sale.
After that, the fourth step is to look for a replacement property. Keep in mind that an investor has 45 days only to look for and identify a replacement property after his old property has been sold.
The fifth step is to sell the relinquished property.
The sixth step is to identify the replacement property and then the investor is given 180 days to purchase a replacement.
Learn more about the steps of 1031 Exchange Rule 2019 here.
6. Who Will Hold the Money During the 1031 Exchange Process?
During the process, the investor is not allowed to hold the money made from the sale of his property. That money must be kept by the chosen qualified intermediary of the investor until it will be used to purchase the property to be used for replacement.
The qualified intermediary would then ensure that the title and the tax of the old property will be the same as for the new property.
To further understand how an investor can better choose a qualified intermediary, it is advised to look at the treasury regulations.
7. How Many Times are Investors Allowed to do a 1031 Exchange?
There is no limit to how many 1031 exchanges an investor can do. The only requirement is that if an investor is exchanging a property, it must be of the same nature, and the value of the property that will be used for the replacement must be of the same value or of higher value.
There are some cases, however, wherein an individual does a lot of 1031 exchanges. This makes that individual some sort of a dealer.
In cases like these, that individual must prove that he or she is using those properties for investment purposes in order to continue using 1031 exchanges.
Read here to know more about the criteria for performing a 1031 Exchange.
8. Three Property Rules that Must be Remembered
Three Property Rule:
This means that you can identify a maximum of three properties that has the potential to be used as replacement property.
It is not necessary to buy all the three properties and you can just choose one of them.
It is also important that the address on the identification paper is complete and must be signed before handing it over to the intermediary that handles the 1031 exchange.
Two Hundred Percent Rule:
It is possible to identify more than three properties. However, the total market value of the identified properties must not exceed 200% of the market value of the properties which you have sold.
If the investor had taken the path of identifying more than three replacement properties, then he or she must settle the deal at 95% of the combined properties during the exchange period within the 180-day rule in order to avoid being charged with tax.
9. Risks of 1031 Exchange
The risk factors of the 1031 exchange can be found in the Private Placement Memorandum. These risks must be understood well by the investor in order to avoid profit loss. This will also help him or her to use the 1031 rule to his advantage.
These are the things that you need to know regarding the 1031 Exchange and 1031 Exchange Rules 2019.
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