A Section 1031 exchange of the Internal Revenue Code allows users to defer payment or taxes on a gain from the sale of investment property. It can be a valuable tool if you reinvest the proceeds into a new property and fulfill the code’s requirements. But, you must do it properly to call it a real estate investment success. Here is everything you need to know about Section 1031.
Tax-deferred, not tax-free
The first thing you should know about Section 1031 is that it is tax-deferred, not tax-free. This means that when you transfer the basis from one investment property to another, you preserve the gain for recognition later. When the replacement property is eventually sold (not part of a later exchange), the original deferred gain plus any additional gain from the sale of the replacement property is subject to capital gains tax.
Taxes may be deferred forever
The next thing about Section 1031 is that there is no limit on the number of 1031 exchanges you can make. So, you can roll the deferred gains on an investment property all the time and eventually pass the real estate investments to the heirs. They will never have to pay the accumulated gain when they receive a step-up basis.
No to primary homes
The 1031 can only be used for investment and business property and doesn’t apply to primary homes in any location that you desire within the USA. It may be used for personal property, like a valuable painting or gold, but that is it. Also, certain types of property are expressly excluded from Section 1031, such as stock shares, equity securities in a corporation, partnership interests, and shares of trusts.
Strict time limits
Sometimes, the 1031 exchange closes simultaneously on sale and purchase. However, you must meet two strict time limits unless you want to pay taxes on your gain. The first time limit is within 45 days of the sale date. In writing, you must identify potential replacement properties to the qualified, responsible person holding the sale’s proceeds.
The second one is that you must complete the transaction at most 180 days after the sale of the exchanged property or the deadline of the income tax return for the tax year in which your property was sold.
The proceeds from the sale are untouchable
You can’t use the money from your asset sale before the exchange is complete because doing so will disqualify the entire transaction, and the gain will be immediately taxable. If you want to avoid receiving proceeds, use a qualified intermediary who will hold those proceeds until the exchange is complete.
Size matters
The size or value of the investment in the replacement property must equal or exceed the net proceeds you gain from the sale. If you don’t reinvest any net proceeds, they will be treated as capital gain for tax purposes. The value of liabilities you assume with the replacement property, like the amount of the mortgage, must equal or exceed the value of the liabilities you relieve yourself of when you dispose of your old property.
Potential pitfalls and how to avoid them
There is a risk of missing critical deadlines or failing to meet the like-kind property identification requirements. If such obstacles arise, the financial advisors can help you with their expert guidance on property selection, or you can work with qualified intermediaries to ensure that all necessary steps are taken before any beautiful occur.
Naming multiple replacement properties
The IRS allows you to name more than one replacement property without regard to its fair market value. However, you must close on one of them within 180 days. In addition, you can name any number of properties as long as their fair market value does not exceed 200% of the Fair market value of the old property as of the transfer date.
Conclusion
The 1031 exchange is one of the most powerful wealth-building tools still available to text payers in the real estate industry. Considering that the capital gains taxes are around 15% and 30%, you can easily see why it is such a popular trend and part of the success strategy of numerous real estate investors. However, to make the success, you need to go through all the rules and regulations carefully and even talk to professionals and experts in the field.
