1031 Exchanges allow property owners to sell existing investment property and acquire replacement property while deferring capital gains and depreciation recapture taxes. In order to use 1031 exchanges, real estate investors must reinvest 100-percent of the equity into "like-kind" property of equal or greater value.
1031 Exchanges can be somewhat complicated. Experts recommend hiring a Qualified Intermediary (QI) to handle every aspect of the real estate transaction. QI's ensure all documentation and money transfers meet guidelines set forth in Section 1031 of the Internal Revenue Code. Careful consideration should be given to hiring a Qualified Intermediary. One small mistake can lead to hefty penalties and taxes imposed by the IRS.
There are two time requirements that must be strictly adhered to in 1031 Exchanges. The first time limitation requires a "Replacement Property" to be identified within 45 calendar days of the transfer of the "Relinquished Property". This is called the "Identification Period".
The second time limitation is called the "Exchange Period". The exchange period begins on the date the "Relinquished Property" is transferred and ends 180 calendar days thereafter. The exchange must be completed during the 180-day Exchange Period.
Another crucial stipulation of 1031 Tax Deferred Exchanges requires relinquished property and replacement property must be held as real estate investments. This stipulation is broadly defined and allows investors to sell one type of investment property for a different type of property. For instance, using 1031 exchanges, investors could sell raw land to purchase an apartment complex, or sell a warehouse to purchase raw land.
Investors are prohibited from accessing equity money between the sale of relinquished property and purchase of replacement property. The Qualified Intermediary must hold all proceeds and prepare legal documents required to link together 1031 exchange properties.
Replacement property must be titled exactly the same as relinquished property. For example, if relinquished property was titled as Jane Smith Investments, replacement property must be titled the same. It could not be titled Jane Smith or JS Investments.
Real estate is not the only property which can be exchanged using 1031. Investment property can include equipment used in the investor's trade or business. However, all investment properties must be traded for like-kind property. Real estate must be replaced with real estate and equipment must be replaced with equipment.
1031 Exchanges cannot be used to exchange a personal residence or vacation home; unless the property is rented out. Additionally, 1031 Exchanges cannot be used to exchange inventory, stocks, bonds, or a partnership interest.
Capital gains taxes are deferred as long as exchange funds are used to purchase like-kind investment property. This tax deferment is like receiving an interest-free loan on the tax dollars that would have been owed for a cash sale.
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