Everything You Need To Know About Section 1031

Everything You Need To Know About Section 1031

You generally pay tax on the gain you make from selling off a piece of investment property at the time of the sale. You then effectively traded one property for another if you use the post-tax proceeds to purchase another property that you later sell for a gain. However, this means you were taxed twice along the way. Fortunately, tax deferred “exchanged” of properties has been allowed by the tax code stated in Section 1031. If you’re an investor who makes good money from property investments, then it’s best to know what Section 1031 is all about and read on.

Selling a piece of investment property and avoiding the payment of capital gains tax by acquiring a replacement property is the basic gist of Section 1031. Some people may say it’s simple to understand, but a very specific set of rules along a very tight timeline to qualify for the deferred tax treatment is involved in this transaction. Although, this transaction eventually would allow investors to save a sizable chunk of gain. There is a relatively small price to pay if you jumped through the necessary hoops. Let’s breakdown the general requirements and the timeline for this complex transaction.

Qualified Intermediary

The use of a Qualified Intermediary is required by each Section 1031 transaction. This is sometimes referred to as either a 1031 Exchange Accommodator or 1031 Exchange Facilitator. They are assigned into the Purchase and Sale Agreement or Contract and any Escrow Instructions before the transactions are closed. Otherwise, the transaction does not qualify. To make sure that the transaction is properly structured and has essentially step into your shoes as buyer or seller of the specific property making the transaction valid, the Qualified Intermediary was created.

Replacement Property

A very specific type is required from the property you choose as a replacement property. First, the net value of the property being sold less than or equal to the net purchase value. The sale of Property 1 net proceeds must be invested into Property 2. Similarly, an equal amount of debt on Property 2 must be replaced by the paid off debt from Property 1. You are allowed to put more cash into Property 2, but there is depreciation capture or capital gains tax liability that comes from any cash you pull from the sale of Property 1. However, it’s important to note that a Section 1031 exchange is not necessarily a 1-for-1 swap. For the purchase of a single property, multiple properties can be sold and vice versa. To structure these exchanges and nuances that go along with them, there are many ways that can be used.

Second, it’s required that a property has a qualifying use. This means the property must be held as an investment or rental property, or in the course of the owner’s trade or business, the property must have been used. It should not just be an inventory for sale. As long as the property meets the qualifying use requirement, there’s no need for it to be the exact same kind of property or type of use.

What happens in a transaction?

Although the transaction can take several forms, all of them follow a basic set of rules. To identify potential replacement property, the investor must first have 45 days from the close of Property 1. To complete the exchange, he must also have 135 calendar days. The “three property identification rule” is the most common rule used in these exchanges where the investor may identify up to three potential like-kind replacement properties. In the even the preferred replacement property transaction hits a snag, identifying three properties gives the investor alternatives. For those who wish to identify more than three properties, there are future more complex rules to follow.

A much-needed break from taxation when essentially swapping one investment for another is provided by Section 1031 transactions. Not only that, it also gives investors more flexibility possible. If you have further questions about Section 1031 or anything that involves taxes towards your properties, you may want to consider consulting a tax professional. Asking for professional help will great reduce the time, money, and effort you spend from fixing your property taxes. 

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