Most experts generally agree that now is the best time to invest in tax-deferred exchanges. This has been largely attributed to the dramatic change in real estate prices in many US cities over the last decade or so. One of the most popular tax-deferment strategies among the most financially successful investors is the 1031 Exchange, sometimes known as a Like-Kind Exchange or Starker Exchange. Here is a brief overview of the 1031 exchange and how to execute one.
What is a 1031 Exchange?
A 1031 exchange basically means swapping one investment property for another while incurring zero to limited taxes during the exchange. You can do a 1031 as many times as you want, rolling over the capital gain from one piece of investment to another, and another, and so on. The idea is to generate a profit on each exchange and then hopefully pay just one tax after a long-term capital gain when you cash out many years later.
Traditionally, the term “1031 exchange” was used when two properties of “like-kind” were literally swapped with each other. However, it is extremely difficult to find someone who has the property that you want and is willing to exchange it with what you have. This is why most exchanges today are Starker, three-party, or delayed exchanges. These usually involve a middleman to facilitate the exchange. Once you “sell” your property, you hand the cash over to the middleman who then uses it to “purchase” the replacement property on your behalf.
How to Perform a 1031 Exchange
To conduct a 1031 exchange, you must successfully swap two properties of similar value without incurring sales tax, at least until you cash out. The primary requirement is that the current property and the replacement property be of the same price. There are two important timing rules you also need to observe.
The first rule involves designating a replacement property. Once your property is sold, you should not receive the cash – the money should be handled by the intermediary. You are required to specify to the middleman for the property you want to acquire by putting it in writing. You must do this within 45 days of your property being sold. You can designate up to three or more properties, as long as they meet certain valuation tests.
The second rule involves closing. You must finalize the purchase of your new property within 180 days after selling the old one. Keep in mind that these two periods of time run concurrently, meaning that the 45 days of designating a replacement property and the 180 days of closing the new purchase start as soon as your old property is successfully sold.
If there is any cash left after acquiring the replacement property, the middleman will forward it to you after the 180 days. This money is referred to as “boot,” and it is considered as partial sales proceed. It will, therefore, be taxed as such, typically as a capital gain from the sale of your property.
There are several legalities that come into play when investing in real estate. If you need the guidance of an experienced attorney to help you adhere to the relevant state laws and yo guide you through the process of a 1031 exchange, Danilson Law has you covered. Contact us today at 515-512-5500.
