Many savvy investors are well aware that a 1031 exchange is a smart strategy for diversifying their real estate investment portfolio and building wealth faster than would otherwise be possible. But what exactly is a 1031 exchange, how does it work, and how do you avoid falling into the common pitfalls beginners find themselves in. Read on to understand more about 1031 exchanges and how they work.
What is a 1031 exchange?
A 1031 exchange is when you exchange an investment property of the like-kind or the same type. It is a strategy permitted under section 1031 of the internal revenue code since 1921. Congress passed the statute to eliminate taxation of ongoing investments in property to encourage active reinvestment. Therefore a 1031 exchange comes with a tax deferral benefit on capital gains tax.
What are the eligible properties for a 1031 exchange?
The internal revenue service defines property of like kind as that of the same nature or character as the one being replaced. It considers real estate property like-kind regardless of the quality or how it has been improved. For instance, as a real estate investor, you can swap a small apartment property for a bigger apartment project for an office building.
As an active real estate investor, investing in 1031 properties such as the dist properties for sale allows you to put off paying capital gains tax and ultimately eliminate them through estate planning. Such a strategy helps you remain liquid and employ your capital gains to scale up your real estate portfolio. But you must stick to the strict timeline that should be followed.
Types of 1031 exchanges
In real estate investments, there are five common types of 1031 exchanges.
- A delayed exchange is when one property is being sold and the replacement property purchased within a specific window of time.
- A simultaneous exchange is when the replacement property is bought at the same time the initial property is sold.
- Delayed reverse exchange is when the replacement property is bought before the current one is sold.
- Delayed build-to-suit exchange is when the current property is replaced with a newly built property to suit the investor’s goals.
- Simultaneous build-to-suit exchange is when the built-to-suit property is bought before the sale of the current property.
Note that the funds from the sale proceeds are held by a qualified intermediary and transferred to the seller of the replacement property during purchase.
Some 1031 exchange rules
The three main rules of a 1031 exchange are:
- The new property should be of equal or greater value than the current property being sold.
- The replacement property must be identified within 45days.
- The replacement property must be bought within 180days.
A 1031 exchange enables investors to defer paying capital gains tax when the proceeds from the sale of the investment property are used to buy a like-kind replacement property. The real estate must be for investment purposes, and the replacement property should be identified within 45 days and purchased within 180days. In simple words, a 1031 exchange is similar to acquiring an interest-free loan from the IRS.