5 Steps to Defer Taxes on Your Real Estate Investment with 1031 Exchange
WHAT IS A 1031 EXCHANGE?
The term 1031 Exchange is defined under section 1031 of the Internal Revenue Code (IRC). A taxpayer may defer capital gains and related federal income tax liability on the exchange of certain types of property.
A 1031 Exchange allows an owner of an investment property to avoid paying capital gain taxes when he/she sells an investment property and reinvests the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.
Instead of paying as much as 35% on profit made from the sale of an investment property, 100% of the proceeds can be reinvested in a new investment property or new properties with no tax payment at the time of the transaction, deferring any tax liability at that time.
The 1031 Exchange PROCESS
- step 1DECIDE TO DO A 1031 EXCHANGEDiscuss your situation with your Realtor, CPA, and estate planning Attorney to confirm you want to upgrade your investment property without paying capital gains taxes. It’s not just about deferring capital gains taxes, but making sure to address your long term financial goals.
- step 2SELL PROPERTYSell your relinquished property then transfer all proceeds to your Qualified Intermediary (QI) while you find a replacement property. When the sale of your relinquished property is closed, the clock for a 1031 Exchange starts ticking. You will have 45 days to identify the replacement property/properties and 180 days to complete the whole process.
- step 3IDENTIFY REPLACEMENTYou must identify up to 3 potential replacement properties. At this point, just identify, not buy. This identification must be done within 45 days after the escrow of your relinquished property is closed.
- step 4BUY REPLACEMENT PROPERTYYou must close escrow on your replacement property/properties within 180 days of selling your relinquished property.
- step 5CELEBRATE!Because you deferred your capital gains taxes AND have upgraded your original investment property to achieve your specific investment goals, which may include improved return, long term financial plans, or estate planning goals.
You can repeat this process again and again to increase your Real Estate Portfolio Value as well as achieve personal financial and estate planning goals!
The 1031 Exchange BENEFIT
Replacement property can increase rental income, restart tax depreciation benefit, or avoid potential costly assessments on older properties.
Move equity to different property types such as land, residential and/or commercial to achieve greater return or diversify risk.
Move equity to different market such as mature market where appreciation is maxed to appreciating market in a different area or even different state.
Spread equity in one property to multiple properties, diversifying risk or accomplish estate planning goals.
Move equity to retirement destination property or multiple properties for multiple heirs to avoid family disputes.
The 1031 Exchange RULES
- USE OF PROPERTY
Both your relinquished and replacement property must qualify as investment or business use. You must hold the property as investment or business for generally one year and one day.
- TITLE MUST BE IDENTICAL
The title of the owner cannot be changed. The owner of relinquished property and the replacement must be the same.
- ALL MUST BE REINVESTED
All profits and proceeds from the sale of the relinquished property must be reinvested into the replacement property.
- 45-DAY IDENTIFICATION
45 days to identify replacement property/properties. 45 days starts from the day the escrow of relinquished property is closed.
- 180-DAY EXCHANGE
The purchase of the replacement property/properties must be closed within 180 days from the date the relinquished property escrow is closed.
- Qualified Intermediary (QI)
You must work with an independent QI to prepare the legal documentation and facilitate your 1031 exchange.