1031 Exchange and Reverse 1031 Exchange
What is 1031 exchange?
The term “1031 exchange” is derived from Section 1031 of the U.S. Internal Revenue Code. Generally, the sale of an investment property at a gain often attracts the capital gains tax. Section 1031 of the U.S. Internal Revenue Code provides an exception to this rule by allowing the owner to defer paying the capital gains tax when they sell an investment property and reinvests the proceeds of the sale in a similar or like-kind property within the set time limits.
Advantages of 1031 exchange.
1031 exchange has several advantages which makes it attractive to investors. These advantages include:
The 1031 exchange gives the investor an increased purchasing power. It allows the investor to use all the proceeds of the property sale including the portion that would have been set aside to pay taxes to invest in another property that has greater potential and value.
The 1031 exchange allows the investor to diversify property ownership. The like-kind property requirement does not necessarily mean that the property to be sold has to be exchanged with an exact property. This flexibility means the investor can acquire different types of properties provided the properties’ primary use is investments, trade, or business.
The 1031 exchange can be used by the investor as a way to upgrade or relocate into better properties that would give them the desired cashflows. If the current property is not bringing in the expected returns, the investor can opt for a 1031 exchange for a new property that is in a better location rather than using time and resources to improve the current property with the hope that it will fetch better returns.
1031 exchange allows the investor to reset the depreciation of the property which in turn reduces the amount of income tax payable by the investor.
What is reverse 1031 exchange?
This refers to a property exchange transaction where the investor acquires the replacement property first before the current property is sold. This is also a strategy to defer the capital gains taxes that would normally be paid after the sale of a property.
Reverse 1031 exchanges are common in instances when an investor needs to close on a sale of a new property before they can sell the current property. For reverse 1031 exchange transactions, the investors have 45 days to identify the property that is to be sold and 180 days to complete the sale of that property.
One important consideration for a successful reverse exchange is that the investor should have enough finances to facilitate the purchase of the new property as most lenders are usually unwilling to finance the reverse 1031 exchange.
Advantages of reverse 1031 exchange
The advantages of reverse 1031 exchange are as follows:
If you are in a highly competitive market, with a reverse 1031 exchange, you don’t have to wait for your current property to sell in order to acquire the replacement property. This means that you won’t lose the opportunity to buy your desired property because you don’t have to wait for your current property to sell.
When the investor lists the relinquished property after acquiring the replacement property, they gain more control over the pricing and other contract terms of the relinquished property.
How does one do a 1031 Exchange?
Below are the major steps you need to take to complete the 1031 exchange.
Identify the property you want to sell. The primary use of the property should be business or investment-related.
Identify the property you want to buy. The property you want to sell and the one you want to buy should be “like-kind”. According to IRS, like-kind property refers to property that is similar in nature, class, and character regardless of grade and quality.
Chose a qualified intermediary who will complete the exchange transaction on your behalf.
Be aware of the timelines within which you should complete the transaction and work within them. Once you sell your property, you have 45 calendar days within which you should identify a replacement property. The replacement property should also be purchased within 180 calendar days from the date you sold your old property.
File IRS Form 8824 with your tax returns. This form will inform the IRS about the exchange transaction.
What companies are recommended?
Top companies for 1031 exchange transactions that the investors can consider using to defer the tax liability are:
- IPX 1031
- First American Exchange Company
- Exeter 1031 Exchange Services LLC
- Strategic Property Exchanges LLC
Contact me if you need help with the Sale or Purchase of your Property and if you need to do either of these types of exchanges so that I can walk you through the process.