You could benefit from a 1031 exchange if you are thinking about selling property that might result in a huge profit. Under normal circumstances, you might end up paying a large amount of tax in the form of capital gains tax on the profit. A 1031 exchange can help you defer the payment of the taxes if you decide to purchase a different property to substitute the one you had before.
What is a 1031 Exchange?
The U.S. Internal Revenue Code, Section 1031 Exchange, can help you postpone the payment of capital gains taxes if you sell a business or investment property and buy a similar (“like-kind”) of property with the funds.
What Qualifies As A 1031 Exchange?
A 1031 exchange only applies to a business or investment property. So if you are thinking about 1031 exchange as a way to upgrade your current home or a vacation home – it doesn’t work that way. Similarly, bonds, certificates of trust, debt instruments, inventory, partnership interests, stocks all do not qualify for a 1031 exchange.
How Does A 1031 Exchange Work?
Do not hesitate to contact a qualified tax professional because a 1031 exchange can be a difficult process. Here you can find a step-by-step process to help you understand the basics of a 1031 exchange.
Step 1: Locate The Property You Want To Sell
A 1031 exchange only applies to business or investment properties. Residential property or vacation home does not qualify for a 1031 exchange.
Step 2: Locate The Property You Want To Purchase
The property you sell and the property you want to purchase must be a “like-kind” property. For example, if you have a warehouse, you should be looking for another warehouse. Similarly, if you have a restaurant, you should be trying to find another eatery to replace it.
The two pieces of real estate do not have to be of the same quality or grade. You can sell an older piece of real estate for a newer property. The key to remember is that U.S. property is not similar to property outside the U.S.
Step 3: Find A Qualified Intermediary
Work with a qualified intermediary, also known as an exchange facilitator to make sure you do not receive funds earlier than expected. The reason for this is that you do not pay any income tax if you do not receive the proceeds from the sale. Choose an intermediary wisely because they will hold the funds as a guarantee for you until you choose the new property after selling your current real estate.
Step 4: Allocating Funds
The price of the property you expect to buy must be equal to or more than the price of the property you sold. You might not qualify for a 1031 exchange tax deferral if you select a property that costs less than the property you sold.
Step 5: Following The Timeline
You can find three different replacement properties within 45 days from the day you sell your original property. You need to share the information about the potential properties in writing with your qualified intermediary. You must purchase the new property within 180 days from the day you sold your original property.
Step 6: Keep Track Of Your Money
The key point for the 1031 exchange is that you don’t pay income tax because you didn’t receive funds from the sale of your property. Make sure you follow the money trail until you purchase the new property. Avoid transferring the amount in your name because that could make it immediately taxable.
Step 7: Inform The IRS About The Transaction
The IRS will require you to inform them by filling up a specific form for the transaction.