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What is a 1031 Exchange and how can they save you money?

When you sell a piece of real estate, income taxes are due on the gain from the sale.  For example, if you purchase a property for $100,000, and several years later, sell it for $300,000, income taxes will be owed on $200,000 (the gain). 

When you sell a piece of real estate, income taxes are due on the gain from the sale.  For example, if you purchase a property for $100,000, and several years later, sell it for $300,000, income taxes will be owed on $200,000 (the gain).  If you have held property for a long time, or if you were gifted property from a relative, the gains can be substantial and can lead to a huge tax bill.

Fortunately, there is a way to avoid this large tax bill when selling property.  The answer is a 1031 exchange.  Section 1031 of the Internal Revenue Code (IRC) allows for an owner of property to “swap” one piece of “like kind” property for another.  The IRS has specific rules that define what makes property “like kind” but a general rule is that if the property was owned for investment or business purposes, another investment or business property will be considered “like kind.”

Most individuals who have read this far in the article are wondering how to swap property.  Most people are not able to find another property owner who would trade their piece of real estate for theirs.  This is where a 1031 exchange company or “qualified intermediary” comes into play.  The IRS recognizes that this scenario is unlikely so they allow for the qualified intermediary to step in and facilitate the exchange.  Here’s how it works:

  1. The property owner decides that they want to sell their property and use a 1031 exchange to avoid income taxes on the sale.
  2. They list the property for sale and contact a qualified intermediary to facilitate the exchange.
  3. The property owner accepts an offer and informs the settlement company that all closing funds are to be wired directly to the qualified intermediary.
  4. The property owner then has 45 days to identify the property they want to purchase.
  5. The property owner must close on their newly identified property 180 days after the sale of the original property.

This “delayed exchange” is the most common way that 1031 exchanges take place and in the eyes of the IRS is a non-taxable transaction.

Key Points to Consider

  • The most important 3 steps that the property owner must take are (1) to contact the QI prior to the sale of their property and the owner must never have possession of the closing funds (even if they deposit them for one day then transfer them to the QI, the like kind exchange will not work); (2) they must identify their new property within 45 days; and (3) they must close on the new property within 180 days.
  • If a property owner finds a property they want to purchase, but they have not yet sold their current property, this can be accomplished and is called a “reverse 1031 exchange” the qualified intermediaries will charge significantly more money for these because money must be lent by the QI to purchase the property before the sale of the original property.
  • If the property being purchased is less expensive than the property being sold and there will be money left over, this is called “boot” and will be subject to income tax.

Like kind exchanges can be a powerful tool for investors and allow individuals to purchase a new property when they relocate, step up into a nicer or larger investment property, or to better diversify their real estate holdings, without the burden of a large tax bill.

If you have questions or would like to find out more about 1031 exchanges, please contact Cherewka Law at (717) 232-4701.

Sep 22, 2021 | Articles, Real Estate

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