The 1031 exchange is the most powerful tool in the real estate arsenal. It’s the tax code that lets you exchange one rental property for another and not pay taxes on the profit. Simply put, it’s a tax-free exchange of real property.
If you’re an investor in the real estate market and you don’t make maximum use of the 1031 exchange, you’re simply shortchanged yourself. You need to use this exchange to your advantage.
There are various rules associated with the use of 1031 exchange in real estate and every single one of them needs to be followed. We have prepared this guide for you to understand the rules associated with the use of the 1031 exchange. We have also included the types of 1031 exchanges available. Read to the end!
Basic Rules to Follow in 1031 Exchange
There are different tax rules for selling a home in the United States and 1031 exchanges help you avert most of it. The 1031 exchange is an extremely powerful real estate investment tool. However, there are certain real estate 1031 exchange requirements that need to be met, such as:
It Has to Be an Exchange
The exchange is usually indirectly between the taxpayer (owner of the asset) and the exchange company. It’s not between the taxpayer and the buyer or seller of the property that’s being sold or the replacement property.
Typically, when you want to sell a property to be replaced by another, the 1031 exchange real estate company steps into the deal and turns it into an exchange by making adequate use of the assignment agreement. This agreement lets the 1031 exchange company or escrow be in charge of the exchange.
The basis of this exchange is that something is given out and another is being received. A relinquished property would give way for a recovered one.
Relinquished Property and Recovered Property Have to Be of Like-Kind
Any real property which is held for investment has to be similar to any acquired property with the intent to be held for investment. The truth remains that finding replacement properties in a short timeline is extremely difficult. For that reason, most exchanges are delayed.
In the advent of a delayed exchange, you need to consider hiring the services of a licensed middleman. This leads to a three-party exchange. The intermediary takes the proceeds gotten from the sale of your property and uses it to buy the replacement property for you.
There are two timing rules that are involved in the advent of a delayed exchange.
The 45 Day Rule
This rule is mostly involved with and relates to the selection of a replacement property. It is the period a taxpayer has to identify with their kind of property (property that is similar in nature and character with the one they sold).
The identification period is 45 days, it begins the day you sell your property and ends at midnight of the 45th day. The Internal Revenue Service allows you to designate at most three properties as long as you end up purchasing one of them.
The 180 Day Rule
The 180-day rule refers to the exchange period rule. It’s the period that you have to acquire the property that would serve as your replacement property during a 1031 exchange.
You have to make payment for the new property on or before the 180th day after selling the relinquished property, or the date on which your tax return is due.
Upward bidding is also called the Napkin Test. This basically means bidding across or upwards in terms of equity and monetary value between the relinquished property and the replacement property. The napkin test is named so because the inventor scribbled it on a napkin during a seminar.
It’s possible to purchase your replacement property before selling off the relinquished one and still be eligible for a 1031 exchange.
The 1031 exchange business to real estate requires you to transfer the property to an exchange accommodation titleholder and then follow the 45 and 180-day rules respectively afterward.
You’re expected to follow the tax rules for selling a home before your 1031 exchange can be verified.
Types of Real Estate 1031 Exchanges
Most individuals think there’s only one type of 1031 exchange but that’s false. There are a few types of real estate 1031 exchanges and they include the following.
This type of exchange involves selling your relinquished property and buying the replacement property on the same day. You typically do this at the same company and both transactions and costs are settled on the same day.
This option is the most common type of 1031 exchange in real estate. In this type of exchange, there’s a time lapse between when you sell off the relinquished property and when you purchase the replacement.
Sometimes, the time gap could be only a few days while other times it could be a matter of months. The reason for the popularity of this form of exchange is that it gives the investor enough time to complete the transaction.
This is a backward type of process. Here, the replacement property is bought and within 180 days, you sell the relinquished property. The reason for reverse exchanges is that sometimes, the investor might find a deal that’s too good to be ignored and would want to close the property.
They’ll go ahead to purchase the replacement property before actually listing the relinquished property for sale. Comparing equity from the old property to the new one could be a huge challenge in this form of exchange.
The improvement exchange involves the 1031 exchange company purchasing the relinquished property and making changes or improvements to it.
It involves the company making use of the equity gotten from the sale of the relinquished property to improve it, such as a new air conditioning unit or some other item. Many investors have used this method to build hotels and other big buildings.
The application of 1031 exchange in the real estate market sphere is very important these days to avoid excessive taxation.
The aim of this guide is to educate you on the types and rules associated with this amazing real estate tool. We hope you use it properly and get the most favorable deals available.
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