What are the Laws Around a 1031 Exchange in Real Estate Investing?

Investing in real estate is lucrative. Real estate investments offer rental income opportunities and help investors diversify their portfolios.

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Jan 21, 2021

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Consistent cash flow from properties also ensures financial security. You can also sell real estate later on and make huge profits. 

While selling properties can help you make big profits, you would incur a hefty tax bill. How do you defer taxes and maximize profits when selling real estate, then? 

A 1031 exchange is an effective strategy for deferring taxes and maximizing profits when selling properties. This strategy can also help boost your investment power and portfolio value.  

All that being said, we’ll briefly discuss what a 1031 exchange is and the rules you need to know to ensure a smooth exchange. 

Understanding the 1031 Exchange

A 1031 exchange, at its core, is a tax deferment tactic popular among experienced real estate investors. 

This tax break allows investors to sell an investment property and reinvest the proceeds to purchase another property to defer payment of capital gains taxes on the sale. However, the rule is to purchase a “like-kind” property. Note that the term “like-kind” doesn’t refer to the quality or grade but the character or nature of the property. 

The 1031 exchange—which gets its name from Section 1031 of the Internal Revenue Code (IRC)—is also referred to as a like-kind exchange or a Starker exchange. This type of exchange allows investors to move or shift their focus into a different class of real estate without incurring significant tax burdens. 

4 Like-Kind or 1031 Exchange Rules You Must Know

A brief overview of what is a 1031 exchange can help you gain a good grasp of the concept. However, you can master a like-kind exchange successfully only when you familiarize yourself with the basics of the process. 

RealtyMogul explains that 1031 exchanges, from start to end, are complex transactions. The like-kind exchange, while advantageous, is subject to strict rules set forth by the IRS. Failure to follow them can result in the disqualification of the 1031 exchange, resulting in potential capital gains tax liability. 

Besides rules, there are timelines, property limits, and convoluted terminology. Not having a clear understanding of the process will complicate the otherwise smooth process. As an investor, it’s important to familiarize yourself with these like-kind exchange rules:

1. Funds Must be Held in Escrow by an Exchange Facilitator

A key rule of like-kind exchange is that investors cannot receive proceeds from the sale of the relinquished property. The moment you take a personal receipt of the funds of the initial sale, the capital gains tax liability will be triggered. Until you find and purchase a replacement property, a third party must hold the funds in escrow. That’s the ruling of the IRS. 

Consider hiring an exchange facilitator to handle the funds on your behalf until the exchange is complete. Choose carefully, though. You will lose all your money if they flake on you or go bankrupt. 

2. You Have Limited Time to Select and Purchase New Property

If you’re thinking of conducting a 1031 exchange, be quick and as efficient as you can. That is because you don’t have too much time to close on the replacement property. The IRC has put forth two timelines that you must adhere to when conducting a 1031 exchange. 

Both timelines begin the day you relinquish your investment property. For a like-kind exchange, you have no more than 45 days to shortlist potential replacement properties from the sale of your investment property. You must act quickly because this window isn’t flexible and cannot be extended, no matter what. 

The second timeline lasts 180 days. Within this period, you must close on one or more replacement properties to defer capital gains tax. 

3. 1031 Exchanges Don’t Work to Downsize an Investment

Like-kind exchange rules restrict investors from exchanging a larger investment property for a smaller one to cash out part of their investment while deferring taxes. You cannot reinvest the proceeds of a larger property into a smaller property. Instead, your exchange must include properties of equal or greater value. Only then will you qualify for tax deferral. 

4. Not all Properties Qualify for a 1031 Exchange

Only business or investment properties qualify for this tax-deferred transaction. That’s the key rule of the 1031 exchange. Properties meant for personal use, such as a vacation house or your home, don’t count. Even securities and financial instruments such as inventory, partnership interests, debt instruments, bonds, stocks, and certificates of trust don’t qualify for like-kind exchanges. 

To put it all together, conducting a 1031 exchange is straightforward, provided you familiarize yourself with its rules. 

The benefits of like-kind exchanges are many, from tax deferral to portfolio diversification. However, you can reap these benefits only when you close on the replacement property, following all the rules. Consider consulting a tax pro for guidance if you're planning to conduct a 1031 exchange for some sound advice.

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