Savvy investors build wealth by shelving capital gains taxes via a 1031 exchange. A qualified intermediary is necessary for the in-depth information required to execute a 1031 exchange. In this article, you will learn how a 1031 exchange works and how it can aid you as a real estate investor.
What is a 1031 Exchange?
1031 Exchange comes from the U.S. Internal Revenue Code, Section 1031. It lets real estate investors avoid paying capital gains taxes when selling a property and then reinvesting in a replacement property.
A 1031 works as a swap of one investment property for another. For this reason, it is also called a like-kind exchange. The name “like-kind” refers to the condition that the properties in the exchange must be similar (that is, of like kind). The exchange property must be of equal or greater value than the sold property.
How Does a 1031 Exchange Work?
According to Section 1031 of the IRS code, which is applicable to real estate, investors can reinvest proceeds from selling one property into another within a specific time to avoid paying capital gains taxes, that is, taxes on the growth of an investment when it is sold. An even property swap is rare between two parties; for that reason, the most common type of exchange is the delayed “forward” exchange, where a qualified intermediary receives the sold property funds to be used later for acquiring a replacement property.
What is a Qualified Intermediary?
A qualified intermediary is someone chosen by a property seller to facilitate a 1031 exchange. They oversee the process and its transaction funds. They hold the funds from the first property sale until the funds are transferred to the replacement property seller. They also prepare the legal documents required for the exchange. The qualified intermediary should come from neutral ground and can have no formal relationship with the exchange parties.
1031 Exchange Important Deadlines
- The seller of the first property (also referred to as the Relinquished Property) must identify a replacement property (that is, their new investment property) within 45 days of the transfer.
- The replacement property must be sent to the exchanger within either (1) 180 days of when the first Relinquished Property was transferred or (2) the exchanger’s tax return’s due date for the year the first relinquished property’s transfer occurs.
- These deadlines are not extended even if the 180th or 45th day falls on a holiday or weekend.
- The seller of the first property (also referred to as the Relinquished Property) must identify a replacement property (that is, their new investment property) within 45 days of the transfer.
- The replacement property must be sent to the exchanger within either (1) 180 days of when the first Relinquished Property was transferred or (2) the exchanger’s tax return’s due date for the year the first relinquished property’s transfer occurs.
- These deadlines are not extended even if the 180th or 45th day falls on a holiday or weekend.
What You Need to Know about a 1031 Exchange
A qualified, professional intermediary should handle 1031 exchange transactions. To be qualified, they should not be a family member, friend, acquaintance, or associate of either party involved.
Exceptions
The IRS doesn’t always allow capital gains tax avoidance. You can’t qualify if the exchange has any of the following characteristics:
- it involves exchanging U.S. real estate for another country’s real estate
- it consists of property for personal use
- it occurs between related parties, and either one disposes of the property within two years of the exchange
Why Do Investors Use a 1031 Exchange?
- They can put down the money they would have paid in capital gains taxes on a replacement property, improving their buying power.
- They could save 15% to 20% off federal capital gains taxes.
- There could be savings at the state level (this varies by state, so you should consult your qualified intermediary about this information).
- Their paid income taxes could be reduced due to the depreciation of the investment property.
Savvy real estate investors use a 1031 exchange to build wealth over time. To learn further how a 1031 exchange can help, ask your accountant or CPA to help you contact a qualified intermediary. Their guidance is critical in executing 1031, whether swapping two properties or working with a complete portfolio of investment real estate properties.
