What is a 1031 Exchange? And why you need it!
Yes if you have any investment property, even if only a parcel of land and you don’t know what a 1031 Exchange is, then you are missing an opportunity to build your wealth through real estate. My goal, I want to educate all homeowners on the basics of a 1031 exchange.
First before we dive into why an exchange and who benefits from it. Let me explain the tax law we are referring to today:
What Does 1031 Really Mean…
IRS section 1031 states: No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.
So why an exchange? Well for one, unlike a primary residence when there is gain on the sale of an investment property the owner must pay taxes on any gain. So the number one reason to exchange is to defer capital gains tax which can be quite substantial. Other reasons, sell one for another for greater wealth building. Or sell one and buy two or more.
Like Kind in a Nutshell…
Now I feel like it is important to explain what “like kind” is. Does the taxpayer have to trade like-for-like such as a condo for condo. The answer my friend, is no! Any property that is held for investment purposes is considered like kind. Readers do you catch my drift? That means you can take a residential property and grow your wealth and maybe do it through commercial or multi-units. OR say you own raw land and want to exchange into a profitable monthly investment home — all of these qualify.
When the Clock Starts Ticking…
Now exchangers beware, As a seller you must be working with a Qualified Intermediary(QI) prior to closing on either property, which we will discuss more below. The IRS states to ensure one does not have “constructive receipt of funds” the QI needs to be involved with the closing title team and all must be done PRIOR to close on the relinquished property.
Once established, there are tight IRS timelines called the Exchange Period, which is 180 days and it starts the day one closes on the first relinquished property. Within this is a small identification window of 45days. This means the Exchanger a.k.a Seller must identify in writing a property or properties they want to purchase within this 45day time period; again this timeline doesn’t start until the day one closes on their relinquished property. Do take note, no changes are accepted after this 45th day and everyday counts even holidays and weekends.
Now this identification window seems to cause a lot of fear and stress. So it’s time to retrain your brain, time to realize if you can look ahead then you can make this process a lot easier than perceived. Once you know you want to do an exchange don’t wait to start looking. You may go into contract on the replacement property before your relinquished property closes. Then you have time to do your due-diligence and make sure all those inspections and appraisal issues don’t arise later in the process.
Who can Help With the Exchange?
Now starting a 1031 exchange is easy, once you find you want to participate in an exchange, you need to find a Qualified Intermediary (QI) also known as an Accommodator. They act as the middleman to hold your funds so you don’t receive “constructive receipt of funds” which is an IRS rule. The QI will help guide you through the process from start to finish. Another note, a title company is not a Qualified Intermediary but they can refer you to one. So don’t assume title holds the funds and be sure to get into exchange contract prior to the close of your relinquished property. Once you close on one you can’t go backwards in the process…another IRS law.
With this being said, know your facts. If you have made a substantial amount of gain on an investment property you need to know a 1031 is the only way to defer your taxes. Don’t let your gain be wasted. Wealth build and keep those dollars working for you verses paying in tax dollars!
Regional Sales Executive | Old Republic Exchange Company
C: 480.341.2032 | T: 480.443.6830 -AZ | T: 818.543.6584 -S.Cal | Mitel: 45229
Old Republic Exchange | Old Republic Insurance Group
With 20 years of RE background in commercial and residential, Sheila is part of the national sales team for a Qualified Intermediary dealing with 1031 exchanges.