A 1031 exchange refers to Section 1031 of the Internal Revenue Code, which states that property owners may complete an exchange of properties as long as those properties are of a “like kind.” With an exchange instead of a traditional purchase, property owners may avoid the capital gains tax that accrues when a property is sold. The 1031 exchange provides an excellent opportunity for real estate investors to get rid of properties and acquire new properties without having to pay excessive taxes on them. The 1031 exchange requires an understanding of real estate laws and of the IRS code, but this knowledge can save real estate investors money and get them valuable new property.
Consult a Qualified Intermediary to mediate the exchange and to represent the other seller in the exchange. The Federation of Exchange Accommodators (FEA) provides Qualified Intermediaries who are trained to handle 1031 exchanges and who understand all of the complexities of the 1031 tax code.
Present a purchase contract to a seller of a like-kind property. A like-kind property is any property that falls into the same category as the property you are also selling. For example, in commercial real estate, like-kind properties might be a shopping strip mall in exchange for an office or office building. Additionally, like-kind properties might even be one apartment building for a large rental property. For real estate investors who are using like-kind properties under Section 1031, both properties must be investment properties instead of standard residences. (For example, both properties could be rental properties.)
Sign an exchange agreement with the Qualified Intermediary and assign the purchase contract to the Intermediary who will receive the title and the funds and then transfer them to the other seller. Once both parties sign the contract and complete the transaction, the property exchange is considered closed.
Complete and file IRS Form 8824 when you file your annual taxes. IRS Form 8824 indicates that a like-kind exchange has taken place, and you will be able to defer or eliminate any capital gains tax with this form.
The 1031 exchange is exclusive to commercial properties or investment properties. If the properties being exchanged represent the primary residences of the respective owners, the 1031 exchange clause cannot be used, and the IRS will apply capital gains taxes to the transactions.
In some cases, a second home or a vacation home may fall under Section 1031, but real estate experts suggest consulting a tax attorney before claiming the exchange.
Bear in mind that the 1031 exchange has a time limit: when a property is sold the previous owner must identify the exchange property within 45 days. And Section 1031 provides both taxpayers a total of 180 days to close on the properties.
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