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1031 Exchanges in Real Estate: How to Reduce the Tax Burden
Owning real estate property can be extremely valuable, but investors are often faced with a dilemma when trying to sell their real estate—especially when the market is hot—because of the big capital gains tax they will face.
However, if you’re a strategic real estate investor, or an advisor to those in this situation, you most likely know about a 1031 Starker Tax Free Exchange (Commonly known as 1031 Exchange)—and how it can help defer paying those capital gains taxes. In reference to Section 1031 of the Internal Revenue Service code, a 1031 tax deferred exchange allows owners of a property held for productive use in a trade or business, or for an investment, to defer capital gain taxes by “exchanging” their property for another that is “like-in-kind.” Real estate in the U.S. is like-in-kind, and can be exchanged if they are used in business or held for income or investment. Here are some 1031 exchange examples:
- Mary exchanges her rental home for a small commercial building.
- Rick exchanges his vacant lot for an apartment building.
- Kat exchanges her office building for a shopping center.
It’s important to understand, you cannot exchange your personal residence for a commercial building, rental or other investment real estate. It must be like-in-kind. These like-in-kind rules are much more restrictive when dealing with personal property. Restrictions that could disqualify an exchange under IRS Rules are exchanging out of or into (1) a Taxpayer’s principal residence; (2) a Taxpayer’s second or vacation home; or (3) property held for sale (inventory, property flipping, etc.)
The Requirements for a 1031 Exchange
The IRS regulations require a Qualified Intermediary (QI) (this is a third party who acts as an intermediary in the transaction for the exchanger. Under IRS Rules the exchanger is not prohibited to take any proceeds from the sale of the “relinquished Property”). The QI takes possession of the exchange funds and will properly document the exchange and maintain compliance with the rules. At Velocity Title, we understand the ins-and-outs of 1031 Exchanges, and are teamed with an attorney equipped to work with as your QI to get you through the process. The exchange is not much different from a regular sale of one property and purchase of another. We will streamline the process and ensure that all funds are handled properly.
To get the maximum deferral amount, the Replacement Property must be valued at either equal to, or greater than the Relinquished Property you are replacing. It is also possible to exchange multiple properties within one 1031 exchange.
1031 Exchange Timing
One thing your QI will keep you on track with is the timing of a 1031 exchange. There are strict time limits that must be followed with this type of transaction. Potential Replacement Properties must be identified within 45 days of closing the sale of your Relinquished Property. You also must settle within 180 days from the close of your Relinquished Property sale to the close of your Replacement Property sale acquisition.
In a nut-shell, here are the steps for a 1031 Exchange:
- Sell a qualified investment property (“Relinquished Property”)
- Your capital gains proceeds are sent from the closing agent directly to a QI. The Exchanger is not permitted to take possession of any proceeds from the sale of Relinquished Property even for a moment.
- Identify a like-kind property with 45 days (Replacement Property)
- Agree on a sales price with the seller of the like-kind Replacement Property that is of equal or greater value then the Relinquished Property
- Your QI will ensure your capital gains money is wired correctly and ready for the day of settlement on your Replacement Property
- Complete the IRS forms and other closing documents at the closing
- Settle on the new Replacement Property and report the exchange to your accountant
1031 exchanges are a great way for investors to remain savvy and continue to gain money off their investments. Here are some tips for ensuring the process goes smoothly for you or your client:
- Always remember a 1031 exchange is not for personal use
- Be sure your QI is a company or person that knows how to navigate 1031 exchanges and closings
- There are non-negotiable time frames on this exchange: 45 days in which to identify a Replacement Property, and 180 days in which to close on the Replacement Property after sale of the old
How Velocity Title can help you with your 1031 exchange
At Velocity, our in-house attorney, and industry experts, understand the detail involved in ensuring a 1031 exchange closing is completed both timely, efficiently and in conformity with IRS 1031 Rules. Our teamed attorney acting as your QI, will focus on:
- Acting as your Qualified Intermediary
- Processing your exchange in conjunction with your closing and coordinating with your settlement company
- Providing a streamlined and seamless transaction—sign the required documents as QI with no extra steps, and no hoops to jump through
At Velocity our priority is moving you forward, which is why we have staff strictly dedicated to meeting real estate investors needs whether your investment be commercial or residential. To learn more, click here, or contact us today.