Real estate investors can take the advantage of 1031 exchange to ‘avoid’ capital gains tax. The idea is to help investors buy and then sell the property without being subjected to the tax bill. This method is completely legit and legal, as long as you do it by the rules.
If you are able to do this 1031 exchange properly, you can enjoy the great benefits to the highest level, maximizing your investment profits.
More about 1031 Exchange
1031 Exchange originates from US Internal Revenue Code, Section 1031. Real estate investors are able to avoid paying the capital gains tax bill when they sell the investment property and then reinvest the money (from the sale) in another property (or properties) within the certain time limits. The property can be similar to the one they have before or even higher in value.
In order to do this exchange, you will need an intermediary, and a qualified one would be crucial. It can be a company or a person that is willing to help with the 1031 exchange. Their main responsibility is to hold the funds.
So, the transaction flow would be like this: Let’s say that you own a property that wants to sell yours so you can get a new property with equal or even greater value. After you manage to sell the property, the money (from the sales) must be sent to the intermediary. When you buy a new property, then the intermediary would transfer the money to the seller.
Basically, the qualified intermediary would be responsible for keeping (or holding) the money until it can be sent to the seller (of that of replacement property). It would be better if the intermediary has no formal relationship with the related parties being involved in the exchanging property.
Reasons for Doing 1031 Exchange
As an investor, it’s pretty understandable if you want to maximize your gain from your investment. There are several reasons why investors want to do 1031 exchange:
- You own an investment real estate and you want to have an already managed property instead of having to manage one yourself.
- You are looking for a property with better return future or prospects. It’s also possible that you want to diversify your assets.
- You want to consolidate some properties into only one. It can be done for several reasons, such as estate planning or you are planning on dividing one property to some assets
- You want to rest the existing depreciation clock
One of the many perks of doing the 1031 exchange is basically the tax avoidance. This activity enables you to avoid the capital gains tax, allowing more capital for bigger investment within the (replacement) property.
However, let’s not forget that this action has its own downsides. It requires holding time and quite high investment value as the minimum.
That’s why this transaction is perfect for individuals having higher net worth. Moreover, this is the kind of transaction that should be managed (and handled) by only professionals.
Choosing the Right Property
In 1031 exchange, real estate investors are targeting the like-kind property. This kind of property is described and defined on its characteristics and nature, NOT the grade or quality. It also means that there is a wide range of exchangeable (real) properties. For instance, an empty land is exchangeable for a commercial building. Or one industrial property can be ‘swapped off’ with a residential type.
However, you won’t be able to exchange a real estate property for artwork, for instance, because it doesn’t even qualify for the like-kind definition. The property should be held for a while for the investment. It shouldn’t be used for personal purpose or being resale. This typically implies at least 2 years of ownership.
If you want to enjoy the entire benefits of the exchange, the (replacement) property must be equal in value or even greater. You should identify the replacement property (for the sold asset) within around 45 days, and then, you should also complete the exchange entirely within 180 days. To define identification, there are basically 3 rules that you should meet or choose.
- Three property rule. You should be able to identify 3 properties as the potential buy without paying attention to the market value.
- 200% rule. You can identify the unlimited properties (as the replacement) as long as their (cumulative) value doesn’t go over 200% of the sold property’s value.
- 95% rule. You can identify as many properties as possible, provided that you can get properties that are valued 95% of their overall total (or even more).
Consult a professional when you want to talk about your real estate investment. Whether you finally go down this 1031 exchange or self-directed IRA, make sure that you do it properly and correctly.
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