We are about to reveal to you the details of what is one of the best kept secrets in the Internal Revenue Code. The 1031 Exchange is arguably the most powerful mechanism in the Real Estate business that allows you to make money, and keep it with you without having to pay taxes on your profits. This is a valuable tool that allows you to keep the proceeds of your property sale. This mechanism allows those who are trading their properties “up” to retain their profits by deferring the tax liability. It is therefore crucial that whenever you are about to sell a property, you should always first consider a tax deferred exchange before making a traditional sale (and purchase).

So what is the 1031 Exchange?

The 1031 Exchange is basically a strategy and method of selling one property and reinvesting the proceeds in a like-kind™ property and thereby deferring the capital gain taxes. To qualify for this tax deference one must exchange the property in accordance with the rules set forth under section 1031 of the Internal Revenue Code. It is not considered as a normal sale and purchase but as an exchange, and this exchange can offer significant tax advantages to real estate buyers.

Why Should I go for the 1031 Exchange anyway?

There are numerous reasons you should consider the 1031 Exchange before selling your property. Some of the more common ones include:-

• Defer the payment of capital gain taxes.
• Leverage – continue to use your proceeds to further investments.
• An exchange is effectively an indefinite interest free loan from the government.
• Upgrade or consolidate your property investments.
• Diversify risk – own multiple properties rather that just one.
• Relocation to a new area.
• Benefit from the differences in regional growth or income potential.
• Be relieved of property management let the lessee take responsibility to sublet and maintain the property.
• Change property types among residential, commercial, industrial, retail, etc.

So what are the rules of 1031 Exchange?

While it can become a little complex let me outline the basic rules here for you.

• The property that you sell and buy both must be real and used for productive use in a trade, business or for investment purposes.
• The properties being sold and purchased must be ‘like-kind’ (more on this later).
• The proceeds of the sale must be routed through a qualified intermediary and not yourself or your agent otherwise the proceeds will become taxable.
• Only the amount of the sales proceeds that are reinvested will be tax free. Therefore any cash proceeds that you retain will be taxable.

The replacement property must be subject to an equal or greater level of debt than the property sold or the investor will either have to pay taxes on the amount of the decrease in debt, or invest additional cash funds to offset the lower level of debt in the replacement property.

How long do I have to execute the 1031 Exchange?

The timeline allowed to conduct the transaction can be broken down into various parts.

Identification Period : Once you have sold the property you must identify the replacement property within 45 days of the sale. The 45 day rule is very strict and is not extended even if the 45th day should fall on a Saturday, Sunday or legal holiday. So it is better that you actually scout for appropriate properties even before your sale is executed.

Exchange Period : The exchange period is 180 days from the date the property is relinquished. Therefore the replacement property must be received by the investor within 180 days of relinquishment or the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs, whichever is earlier. Again, should the 180th day fall on a Saturday, Sunday or legal holiday, it will not be extended and it treated as a strict deadline.

What are the limitations on the new properties that I can buy under the 1031 Exchange?
One has a variety of freedoms along with limitations when considering replacement property / properties. These are:-

3 Property Rule : You may identify any three properties as possible replacements for your relinquished property. More that 95% of exchanges actually use the 3 property rule.

200% Rule : As long the total value of all the properties that you identify for replacement does not exceed
200% of the value of the relinquished property, you may identify any number of properties as possible replacements for your relinquished property.

95% Exemption : As long as you end up purchasing at least 95% o the aggregate value of all the properties identified, you may identify any number of properties as possible replacements for your relinquished property.
Like-Kind™ Property : According to IRC 1031(a) Like-Kind mean similar in nature or character, not withstanding differences in grade or quality. One class of property may not be exchanged for property of a different kind or class under the 1031 exchange rules.

Here are some examples of qualified 1031 like-kind properties and exchanges:-

• Apartment building for farm/ranch
• Office building for hotel
• Raw land for retail space
• Unimproved property for commercial property
• Airplane for airplane

Whereas examples of non like-kind properties include primary residences, stocks, bonds, notes, partnership interests, developed lots help primarily for sale and property that needs to be resold immediately after the initial purchase or completion of improvements.

So how do I actually conduct a 1031 Exchange?

The normal caveats apply…be sure to consult a lawyer and do not take the guidelines below as completely full and final, etc. etc. but here are the basics:-

Proper Listing : Once you have identified that a 1031 exchange is in your best interests be sure that the listing agreement specifies that you intend to use the property for a 1031 exchange.

Sales Contract : Once you have received and negotiated an offer be sure that everyone is clear about that fact that you are intending to acquire a new property under the terms of Section 1031 of the IRS code.

Facilitator : You will then have to open an escrow account and begin working with a facilitator. The facilitator will prepare all documents required for a 1031 exchange. The facilitator will work with the escrow company during the first phase of the process. The exchange agreement will need to be signed by everyone involved and all the earnest money must be deposited with the title company before the escrow is closed.
Finding a Replacement Property : You will then have to find a replacement property within 45 days of closing. After that you will have 180 days (or less if the investor tax return filing date fall earlier than 180 days) to acquire and close the property making sure that everyone know it is part of a 1031 exchange.
Closing the Replacement Investment : Once you open an escrow account on the new property the facilitator will work on the documents required in phase two of the 1031 exchange process. Until the second phase of the transaction has closed your earnest money and any other funds will be held in a trust by the facilitator in the escrow account.

Those are the basics of the transaction. If sufficient interest is generated about this blog pos then I would be happy to provide more details on points like reverse 1031 exchanges (more complex transactions where the investor buys the replacement property before relinquishing a property), referrals for qualified intermediaries (those who have signed a contract with the IRS for the purpose and have received a QI-EIN) etc.

If you need more details do not hesitate to contact a lawyer, meanwhile, happy 1031 exchanging!

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