Real Estate Investor – Understanding the 1031 Exchange

If you’re someone who owns investment property and are currently considering selling it before  purchasing another property, it’s important to take the time to learn about what a 1031 tax-deferred exchange is.

What is a 1031 Exchange? 

Generally defined, this is a procedure that enables a real estate investor to sell a property before purchasing like-kind property while, at the same time, deferring capital gains tax. The name of this procedure comes from Section 1031 of the United States Internal Revenue Code, which is something that enables you to not pay capital gains taxes whenever you sell an investment property and reinvest all proceeds from the sale within a certain amount of time in a property or other properties of like kind and equal or greater value.

Defining like-kind property

In terms of like-kind property, this is generally defined as property according to its overall nature or characteristics rather than its grade or quality. Essentially, this means that there is typically a broad range of exchangeable real properties. For instance, vacant land will be able to be exchanged for a commercial building, or industrial property will be able to be exchanged for a residential building. On the other hand, you will be unable to exchange real estate for artwork, as this does not meet the general definition of like-kind. However, the property must always be held for investment rather than personal use or resale. This is something that usually implies a two-year ownership minimum.

In order to be able to receive the full benefit regarding a 1031 exchange, a replacement property must be of either equal or greater value. A replacement property must be identified for assets sold within 45 days prior to concluding the exchange within 180 days.

Section 1031 states that all proceeds that are received from a property sale always remain taxable, and for that reason, the proceeds must be transferred to a qualified intermediary instead of the property seller. From there, the qualified intermediary will then transfer them to the seller of the replacement property or properties.

Advantages of a 1031 Exchange

An investor will typically have a number of different reasons why they may consider taking advantage of a 1031 exchange, which can include the following:

  • They could be seeking a property that has better return prospects or could wish to diversify their assets.
  • An owner of investment real estate could be looking for a managed property instead of managing one on their own.
  • An individual could be seeking to consolidate multiple properties into a single property for real estate planning purposes or to divide a single property into multiple assets.

The most common benefit of implementing a 1031 exchange involves the tax deferral, as this enables you to defer capital gains tax, which frees more capital for investment in the replacement property. Keep in mind, however, that a 1031 exchange could end up requiring a high minimum investment and holding time. As a result, these types of transactions will be more ideal for those who have a higher net worth. Additionally, transactions involving 1031 exchanges should always be handled by professionals. If you would like to know more about real estate investing click here.

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