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What Is The 1031 Exchange And Its Rules
If you are an owner of investment property and you would like to sell the property so you can buy a different piece of property, it is critical that you are aware of the 1031 tax-deferred exchange. A 1031 exchange, is also known as a like-kind exchange or starker exchange. It is a convenient strategy that permits an investment property owner to sell the property and purchase like-kind property while putting off capital gains tax in the process.
Real estate prices in a lot of cities in the United States have become really expensive so much so that they well surpassed the bubble price estimation levels over 10 years ago. To effectively use the 1031 exchange strategy, the two properties involved in the trade have to have the same financial valuations. Therefore, a lot of financially successful investors use this strategy to defer tax (There are also other benefits of investing in a 1031 Exchange). The following is an initial breakdown of the 1031 exchange and its rules that govern the process. We have produced a more comprehensive overview of 1031 Exchange Ownership Rules compared to this article.
The term 1031 exchange is defined under section 1031 of the IRS Code. Simply put, it is when a property is literally exchanged for another property of like-kind without having to incur taxes. For instance, if you would like to invest in low-income property with high maintenance, you could exchange the property for a low maintenance investment without having to pay a significant amount in taxes. The 1031 exchange rules make this scenario possible without bringing the IRS knocking on your door. Here are a few rules used to govern a 1031 exchange.
1031 Exchanges Have To Be Direct
At first look, it may seem that no one will ever do a 1031 exchange because it would be so hard to make it work. To do a 1031 exchange, you need to find someone who owns a property you want and they would have to want your property in return. The prospects of finding a willing person are highly unlikely especially if you are looking for a real estate property in a different location with significant environmental and societal differences as compared to the one you own. However, the 1031 exchange rules permit for a third party to be involved known as a ‘qualified intermediary‘. The work of the third party is to assist facilitate two separate transactions that will involve you selling your existing property and buying another piece of property as a replacement. The buyer of your property does not have to be the same as the seller of the property you want thus allowing you to both sell yours and buy the property you want.
You Cannot Use 1031 Exchanges On Your House
If you would like to qualify for favorable treatment from the IRS as far as paying tax goes, the property you use in a 1031 exchange has to be used for commercial gains. This simply means that you can use real estate property used for residential purposes and exchange it for another without paying taxes on any profit made. However, you cannot exchange a business property for a property you intend to use as a personal residence.
Cash You Receive In A 1031 Exchange Can Be Taxed
There is usually a difference in the value of the properties used in a 1031 exchange. This means that if you exchange your property for a property that is more valuable, you might have to add some cash to the seller. Fortunately, this scenario will not impose heavy taxes on you. However, if you receive property with less value than the one you had, and you are the one receiving cash, then the money is subject to capital gains tax. You will find that the cash you receive tends to be less as compared to the total value of the property and therefore you will not pay tax on more than the money you received.