As a savvy real estate investor, one of the best ways of building wealth is to diversify your investment portfolio. If you have an investment property that you are planning to sell and buy another property, you should consider taking advantage of the 1031 exchange. If you have no idea what 1031 exchanges are, you are in the right place as we have dedicated this article to 1031 exchanges to help you understand them and learn how you can optimize them to defer capital gains and build wealth.
What is a 1031 exchange in real estate?
A 1031 exchange in real estate refers to an exchange of one investment property for another that permits capital gain taxes to be deferred. The term 1031 is derived from Internal Revenue Code (IRC) Section 1031 which states that; “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade, business or investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or investment.”
This section can be simplified to mean that when you sell an investment property and use the proceeds to buy another similar investment property, you are not obligated to pay capital gains tax to the IRS.
How does 1031 exchange work?
The concept of 1031 exchanges in real estate is straightforward. It works on the grounds that you will not be required to pay capital gain taxes if you happen to sell a real estate investment property and use the proceeds to purchase another like-kind investment property.
On 1031 exchanges, it’s important to note that IRS is very specific on the specific type of real estate investment properties that you can swap and which ones you can’t exchange. Like-kind properties in IRS terms are investment properties that have similar characteristics even though they don’t share similar quality or grade. For instance, if you want to sell an apartment, you will be required to exchange it with another apartment for you to benefit from deferred capital gain taxes.
On the flip side, a 1031 exchange is not applicable if you want to sell your investment property may be in the US so that you can buy a like-kind property in another country. Real estate properties that have been bought for resales such as land for development, fixer-upper property, or a private residence also do not qualify to be used in a 1031 exchange. However, when it’s used correctly, there is no limit on how many times a real estate investor can make good use of 1031 exchanges.
1031 exchange intermediaries
According to the IRS guidelines, real estate investor is not permitted to carry out 1031 exchanges by themselves. IRS recommends an exchange facilitator or intermediary who will be charged with the responsibility of overseeing the entire process. A qualified intermediary who will act as the escrow agent and hold the exchange funds and the exchange agreement. The choice of an intermediary or facilitator matters a lot in 1031 exchanges.
The intermediary must be a neutral party who does not have any conflict of interest with the real estate investor conducting a 1031 exchange swap. Therefore, an investor can’t use their real estate broker, agent, friend, or relative to facilitate a 1031 exchange. The facilitator also ensures that the right due process is followed during the 1031 exchange and that the entire process is clearly documented so that it can be scrutinized by the IRS for easier taxation.
It’s also important to note that there is a timeline when it comes to carrying out a 1031 exchange. IRS gives investors up to 45 days to select a potential replacement property. Once an investor successfully identifies a replacement property, a period of 180 days is given to purchase the new property. The entire exchange process is required to be completed within the timeline of 180 days for the real estate investor to qualify for the deferred capital gains taxes.