The established real estate investors in the U.S. are already familiar with 1031 exchanges. According to 1031 exchanges, reinvest the proceeds from the sale of any investment property into like-kind property investment in order to defer capital gains tax. This means the taxes on capital gains are not charged on the sale of real property if the money is being used to buy another like-kind property.
So, how does a 1031 exchange work exactly? Let’s understand it with an example. Say, for instance, you buy a property costing $200,000, which is worth $500,000 by the time you sell it. Rather than paying the capital gain taxes on $300,000, the 1031 exchange would allow you to reinvest the proceeds from the sale into another property. Seems simple? Right? In reality, 1031 exchanges are most complex and have many nuances that could be daunting for first-time buyers. There are specific terms and conditions along with some guidelines to govern this process.
Here’s is a brief overview of the types of typical 1031 investment property exchange:
Types of 1031 exchanges
- Deferred or delayed 1031 exchange: This is the most common type of 1031 exchange where the investor closes on the relinquished property, and within 45 days, they have to identify a replacement property. And, for the replacement property to be considered valid, one of these criteria must be valid:
- Three properties rule: An investor may identify up to 3 properties as potential purchases within a 45 days identification period regardless of the total value of the properties.
- 200% rule: According to this, the investor may identify an unlimited number of replacement properties, as long as the total market value of such properties doesn’t exceed 200% of the value of the relinquished property.
- 95% rule: According to this, the investor may identify as many properties as they want, as long as they receive at least 95% of the value of all the identified replacement properties before the end of the exchange period.
In addition to the identification period of 45-days, the investor has 180 days from when they can close on the relinquished property to close on the exchange period. Finally, this kind of exchange requires a Qualified Intermediary, also known as an “accommodator”. The QI is an uninvolved third party that holds the investors’ sales proceeds from the sale of relinquished property in an escrow account until they close on the replacement property.
- Simultaneous 1031 exchange: According to this kind of exchange, the investor closes on the relinquished property and then closes on the replacement property immediately thereafter within one day. The investor may use a QI to handle these funds, but they are not mandatory.
- Reverse 1031 exchange: According to the reverse 1031 exchange, the investor acquires a replacement property before conveying the relinquished property to the new buyer.
There are countless situations in which the 1031 exchange might be a tax-efficient strategy to preserve your capital. If you are thinking of using 1031 exchange for any of your real estate property, we suggest you contact 1031property.com to discuss the transaction in detail.