If you have an investment property, but you’re thinking about liquidating it and acquiring another one, you’ll benefit greatly from knowing more about IRS Section 1031 tax-deferred exchange. This is a strategy that allows you, as the owner of a real estate asset, to liquidate or acquire like-kind properties, allowing you to defer from capital gains tax.
But exchanging and buying 1031 properties for sale isn’t as straightforward as it seems. You need to fully understand many moving parts before trying to utilize them in your following investment strategies. For example, an exchange is limited to like-kind properties, and the IRS has introduced rules to restrict the section’s use of vacation properties. Also, there are some tax implications and time frames that can pose a considerable obstacle for you. Still, if you think this strategy will work well for you, these are the things you should know about 1031 property exchanges.
What Is Section 1031?
A 1031 or like-kind exchange is a trade of one real estate investment property for another. Although most exchanges can be taxed as sales, if you meet specific requirements, you can pay for less or no tax when the swap happens.
So, you can switch the form of your investment without liquidating it or incurring capital gains. This would permit your investment portfolio to grow while deferring taxes. Also, there’s no limit as to how many times you utilize a 1031 exchange. Although a typical exchange will generate profits, you can avoid paying for the tax dues by selling them for cash several years down the road. If all things pan out, you’ll only need to pay for one tax which is a long-term capital gains tax with a rate of around 15-20%, depending on the income. However, this rate can be at 0% if you are a low-income investor.
Most importantly, all 1031 exchanges are limited to like-kind properties. Although the term might imply that all properties involved must be identical, you can exchange an apartment building for an empty plot of land or a farm. The exchange’s rules are also quite liberal, but there are some traps that you need to look out for. To make things easier, you can look out for reputable 1031 property listings to ensure that the property you’re eyeing fits the bill.
Section 1031 is meant for investment and business property, but it can still cover a former main residence if your property meets certain conditions. You can also use this exchange for trading vacation homes, but the loophole to enable this exchange isn’t as lax as it used to be.
What Are The Rules on Delayed Exchanges and Timing?
Typically, exchanges should involve a simple trade between one property for another involving two parties. However, your odds of finding a person with the same property you have is pretty slim. So, most of the 1031 exchanges are either delayed, involve three parties, or Starker exchanges.
You should take note of these two essential timing rules in every delayed exchange:
45-Day Rule
The first rule deals with the designation of a replacement of the 1031 property for sale. Once the sale happens, the intermediary will receive the proceeds. A third party must obtain the money because the exchange would spoil the 1031 process. Also, within 45 days of the sale, you need to identify the replacement property and inform the intermediary in writing, and you should specify the property you want to buy.
The IRS has also specified that you can choose three properties as long as you eventually close one of them. You can also identify more than three provided that they are within a set range.
180-Day Rule
The second rule dealing with timing in a delayed commercial property exchange is about closing. You must close the new property within 180 days of its sale.
Important: The two time periods happen simultaneously, so you should start counting once the sale of the asset closes. If you designate a replacement asset on or after the 45th day, you’ll only have 135 days before you can complete it.
Tax Implications on Cash and Debt
You may have some cash left over after the third party buys the replacement asset. So, they will give you the money at the end of the 180 days. This amount is more commonly known as “boot” and will be taxed as partial proceeds from the asset’s sale or as a capital gain.
One of the most common ways people encounter difficulties with these transactions is by failing to account for debts. You must include the mortgage loans and other liabilities incurred that you’ll relinquish. Also, if the cashback isn’t given back to you, but your debts have been paid off, it will still be treated as your income.
1031 Exchanges For Vacation Homes
You might have heard of stories of some investors who traded their vacation homes for another or even a house they can settle in after retirement. These people also used section 1031 to declare that they didn’t make gains. After some time, they moved into the property, transformed it into their primary residence, and used it for up to $500,000 capital gain exclusion.
This deferment can enable you to put your house up for sale and keep half a million dollars from capital gains tax if you’ve lived in the property for at least two years out of the past five.
Also, you can stop living in your vacation property and rent it out for around six months to a year and swap it for another. But you need to get a tenant and have a business relationship with them for the property to be considered an investment property.
If you only offered it up for rent but didn’t get any tenants, it probably won’t fit 1031 exchange NNN properties. Also, you should leave enough time to convert your asset into a rental to achieve better results. The most common period is more than six months of actual rental use, so a year or more is better.
Conclusion
Buying 1031 property for sale can both be a blessing and a curse. If you’re a knowledgeable real estate investor, you can use it as a strategy to get lower tax rates and build your portfolio. However, the process involves many challenges to grasp, lengthy processes that require your full attention and understanding of the rules. Still, even though you think you know the ins and outs of the 1031 property exchange, you’d get better results if you get help from professionals.
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