1031 Exchange: The Little Tax Code That Makes A Big Difference
If you are a business owner, you need to use all the tax benefits that are available to you. These benefits, deferments, and write offs are created to encourage companies and investors to keep conducting business and keep powering the American economy, and you deserve to use whatever is available.
This includes the 1031 exchange, a useful option that allows you to lower your overall tax liability when buying and selling homes.
If you are planning on selling a property and reinvesting in a new house, be sure to use the 1031 exchange.
Understanding 1031 Exchange
Note: We are not tax experts; this article is for general information and entertainment only. Tax laws are constantly changing, so speak with a qualified professional before making any investment or tax decisions.
What is a 1031 Exchange?
A 1031 exchange is essentially a way to move from one investment property to another without paying capital gains tax. Without the 1031 option, an investor who wants to sell a property, then use the money from the sale to purchase another, would have to pay taxes, often a significant amount. With this option they can basically reinvest and not be burdened by a large tax hit.
This makes it a popular option for investors all over the country, and it’s gaining traction in use and understanding. Essentially, if you change the form of the investment without actually cashing out the funds, your investment can continue tax-deferred. (“Tax deferred” means you pay taxes later.)
One of the features that makes a 1031 exchange so popular is that they can be used as many times as needed. There is no limit to how many times an investor can use the 1031 exchange, so you could conceivably roll the investment from one property to another thousands times and still be eligible for the tax deferment. You may have a profit on each swap, but as long as you keep reinvesting the gains, you won’t have to pay taxes.
The 1031 option is for investments only, so you can’t use it to sell your personal home and purchase a new primary residence. In limited situations, it can be used on the swap of a vacation home, but this is only available in narrow cases.
With this option, you have to purchase a new property within a certain timeframe. If you were to sell your property, realize a gain, and not purchase a new property for about a month and a half, you would be ineligible for the exchange.
1031 Exchange: An Example
To help you understand the advantages of using a 1031 exchange, let’s look at a highly simplified example. While the numbers will certainly differ, this will help you broadly understand why you should use this option.
Suppose an investor sells a property and has a $400,000 gain as well as $400,000 in net proceeds after closing the deal. At $400,000 in gains, you’ll be liable for taxes of roughly $140,000. They means only $260,000 in overall net equity remains from the sale. If you want to then purchase a property with a loan and a 25% downpayment, you would be eligible for roughly $1 million in purchase price.
But if you were to use the 1031 exchange, you would be able to use the entire $400,000 as a downpayment for your next purchase. If the $400,000 was used as a 25% downpayment, you would be eligible for about $1.6 million in purchase price.
So, in this simplified example, you would be eligible for $600,000 more in investment opportunity.
How to Complete a 1031 Exchange
If you are ready to do a 1031 exchange on your property, the process is simple and easy. While you’ll need the assistance of a qualified professional, this step-by-step explanation will give you a basic understanding.
First, you will list the currently-owned property (which we’ll call Property A) for sale. In the listing paperwork, your agent (or you, if that’s the case) will need to include language explaining that Property A will be sold using a 1031 exchange.
Then you will start to search for a replacement property (Property B). You only have a short period (about a month) to roll the proceeds of the sale into a new property, so you should start the search right away.
Once you find a buyer for Property A, be sure that the paperwork states that a 1031 exchange is going to be completed. The buyer will need to comply with this detail, although it won’t impact their purchase process in a significant way. They will likely need to sign certain paperwork, particularly assignments and disclosures, but that is about all.
You will then close the sale of Property A, which will be handled pretty much like any other property sale. The only difference is that your intermediary (the person completing the details of the exchange) will be included in the process. The funds from the sale will be transferred to their bank account, not yours.
The next step in your process will be to find a property that you wish to buy. There are specific details on identifying properties, so work with a tax and investment expert to complete this step.
When you identify the exact property you wish to purchase, you will need to sign a contract and open escrow. You can also go under contract on multiple properties and use a contingency clause to back out if you decide not to pursue one of the properties.
Now the qualified intermediary will work with the title company to make sure all the details are handled properly. You’ll then close on Property B and the qualified intermediary will wire the money to the title company or appropriate attorney. The property will close as normal, and the taxes on the previous sale will be deferred.
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