Most people go to great lengths to reduce the amount of tax they have to pay. For those who invest in real estate, a 1031 exchange can be a valuable resource that allows them to increase their net worth without having to pay up to 35% in taxes.
Named after Section 1031 of the IRS Code, a 1031 exchange is a transaction in which one property is exchanged for another similar one by deferring the tax implication of a sale. If, for example, you buy a property for $250,000 and sell it for $550,000 later on, you can invest the $300,000 into another property without having to pay capital gains tax on it.
1031 Exchange Requirements
The deferred (or delayed) exchange is the most common. After selling your property, you have 45 days to identify other properties of equal or greater value. Once the identification is made, you have 180 days from the time you sold the original property to acquire the new one. For the new property to be considered valid, one of the following conditions must apply.
- You identify up to three potential purchases within 45 days, regardless of their total market value.
- You identify an unlimited number of replacement purchases, as long as their total market value is no greater than 200% of the value of the sold property.
- You identify an unlimited number of exchange properties, as long as you receive a minimum of 95% of their value before the exchange period ends.
Another option is the simultaneous 1031 exchange, in which you close on the replacement property immediately after closing on the sold one, and the reverse 1031 exchange, in which you acquire the replacement property before the relinquished property is conveyed to the new owner.
The new property must be “like-kind,” meaning that it must be another qualifying type of real estate. For example, the investor could sell a parcel of land and buy a duplex or commercial property. Both the sold and newly acquired properties must be held for business or investment purposes: for example, an investor cannot sell their home and buy an investment property. The investor must also not receive cash from the sale, as such money is taxable.
The IRS safe harbor provisions require deferred exchangers to use a Qualified Intermediary or QI to orchestrate the 1031 transaction. These intermediaries are independent third parties who hold the proceeds from the property sale in an escrow account and buy the replacement property on the investor’s behalf.
There are many situations in which a 1031 exchange is a wise investment move. You can shift your investment focus from one area to another or consolidate smaller properties into one bigger investment without triggering a capital gains tax. For assistance in facilitating a 1031 exchange for your next acquisition, contact Rosen Law, LLC at (516) 437-3400. We have in-depth experience with 1031 tax exchanges and have acted as the qualified intermediary in many real estate transactions, so let us help you achieve your investment goals.