We often receive queries from investors asking whether a 1031 exchange is tax-free? Getting confused with the taxes while doing a 1031 exchange is quite normal. Undoubtedly, investors opt for a 1031 exchange to save taxes on capital gains. However, this unique investment structure isn’t tax-free. Instead, it allows investors to defer capital gains taxes if all of its requirements are fulfilled.
Difference between Tax-Defer and Tax-Free –
For most 1031 investors, tax-defer and tax-free mean the same. However, there is a huge difference between both terms. When we say tax-free, we mean no tax is applicable on a particular thing or transaction (in case of an investment). Whereas, tax-deferment means postponing taxes for later. A 1031 exchange allows investors to defer capital gains taxes on exchanging an investment property for another like-kind property. Therefore, using a 1031 exchange, an investor can defer up to 100% capital gains tax for as long as they want (till the last breath).
How can you qualify for a 1031 exchange?
There are a few requirements that an investor must fulfill to qualify for a 1031 exchange. The first and most important requirement for doing a 1031 exchange is that both relinquished and replacement properties must be like-kind. For example, if the relinquished property was a rental property, the replacement property must also be used in the same way.
Another thing that you’ll need for initiating a 1031 exchange is the assistance of a Qualified Intermediary (QI). A Qualified Intermediary is an individual responsible for handling 1031 exchanges on behalf of the investors. As per the rules, 1031 investors must involve a QI in every exchange.
Once you enter a 1031 exchange agreement along with a QI post selling your relinquished property, you must identify one or more potential replacement properties within 45 days. Written identification of the potential replacement property must reach 1031 corp. on or before the midnight of the 45th day. This time frame of 45 days is known as the Identification period. The proceeds from the relinquished property must be transferred to the QI in a third party account, known as an escrow account.
Upon successfully identifying the replacement property, you must acquire the same within 180 days (starts the day the relinquished property is sold). The IRS is quite strict when it comes to adhering to 1031 exchange deadlines. You may not get any extension in case you missed the deadline.
Who is it for?
There is no specific age for doing a 1031 exchange. Neither does it favor investors of any particular age-group. However, this kind of investment could be more beneficial for retirees, who’ve hung their boots and want a steady flow of income for the rest of their life. Swapping an old investment property with a new one can ensure increased and regular flow of income, which is only possible through 1031 exchange.