Introduction: A 1031 Exchange is a common tax strategy that allows real estate investors to grow their portfolios and increase their net worth more quickly and efficiently than they would otherwise be able to. How do 1031 Exchanges work, what types are available, and how can you avoid common mistakes? Follow these steps to learn everything you need to know about 1031 Exchanges.
#1: Understand what a 1031 exchange is according to the IRS
A like-kind exchange occurs when real estate used solely for business or held for investment is exchanged for another business or acquisition of the same type or ‘like-kind.’ A law passed by Congress in 1921 exempts ongoing property investments from taxation and encourages active reinvestment.
#2: Identify 1031 exchange-eligible properties
If the quality is different, but the nature or character of the property being replaced is the same, then it is like-kind. Regardless of how real estate is improved, the IRS considers it like-kind.
In addition to machinery, equipment, artwork, collectibles, and patents, the intellectual property also includes items such as patents.
#3. Examine the five most common 1031 exchange type
Real estate investors commonly use five types of 1031 exchanges. These include:
The delayed exchange involves selling (or relinquishing) a property and purchasing a replacement property during the specified period.
Buying the replacement property simultaneously as selling the current property in a delayed/simultaneous exchange.
Purchase replacement property before relinquishing the current property in a delayed reverse exchange.
The use of a 1031 tax-deferred exchange requires planning.
The three primary 1031 exchange rules to follow are:
The replacement property should be valued at an equal or greater level of excellence
It is necessary to identify the replacement property within 45 days
180 days must pass before the replacement property is purchased
Within 45 days, they identified the problem and planned a solution. Real estate investors should plan before doing a 1031 exchange. The IRS requires 45 days for the replacement property to be placed. Experienced investors do not wait until their property has sold to get the best price before looking for a replacement. After calling a real estate broker with a property listed for sale, you need to find a replacement property within two days. Property deals are unlikely to be good.
180 days are allowed for the purchase of replacement property.
The replacement property must be purchased and closed 180 days after the sale of the current property. It is important not to confuse 180 days with six months. Counting all days, including weekends and holidays (even federal holidays), the IRS determines the 180 days.
Mortgaged properties can also be exchanged using the 1031 exchange.
Exchanges of real estate with existing mortgages are also permitted under 1031 exchanges. A replacement property’s mortgage must equal or exceed that on the selling property, and a boot is applied when there is a difference in value.
Through 1031 exchanges, the IRS provides interest-free loans. Real estate investors can therefore enjoy higher current rental income while growing their portfolios quicker without paying capital gains taxes.