Normally, selling an investment property for more than its purchase price means paying significant capital gains tax. However, a 1031 exchange allows you to defer these taxes by reinvesting the proceeds into a new property, essentially making an “exchange” rather than a sale. This process comes with strict regulations, so it’s important to follow the 1031 exchange rules meticulously.
Section 1031 of the IRS Code allows investors to sell and buy their investments without paying one penny in taxes. Property must be like-kind in nature, but personal property does not qualify. Almost every kind of real estate is considered like-kind and can be exchanged for any other real estate, including property Vacant land for apartments, a rental house for a shopping center, or an office building.
It is a common misconception among investors that like-kind means selling one residential property and buying another residential property. That is not the case. An investor could sell a residential property and buy a commercial property of real estate, and that is considered like-kind by the IRS. Cash, or other assets, which are referred to as boot, is recognized and fully taxable. For example, let’s say the relinquished property sold for $500,000, and the investor turned around and acquired a property for $400,000. Well, what happened to that extra $100,000? The $100,000 the investor kept as cash, that is boot, and would be fully taxed.
Eligibility for a 1031 Exchange
To qualify for a 1031 exchange, you must meet these basic criteria:
- Investment Properties Only: This rule applies strictly to investment properties. The properties involved must be used for investment purposes, such as rentals or properties intended for flipping. Personal residences do not qualify.
- Equal or Greater Value: The replacement property must be of equal or greater value than the one being sold. This means you’re essentially “trading up” in property value.
Key Rules to Follow
• Escrow Account: The proceeds from the sale of your original property will be held in an escrow account managed by a third party. You won’t have access to these funds until you close on the new property.
• 45-Day Identification Period: Post-sale, you have 45 days to identify potential replacement properties.
• 180-Day Purchase Period: After identifying the properties, you have 180 days to complete the purchase.
Additional Guidelines
• Three-Property Rule: You can identify up to three potential replacement properties, provided you close on at least one.
• 200% Rule: You can identify any number of replacement properties as long as their combined fair market value doesn’t exceed 200% of the value of the property sold.
• 95% Rule: If you opt to ignore the 200% rule, you can identify any number of potential replacement properties, but you must acquire at least 95% of their total value.
These rules are stringent, and there are no exceptions or extensions. Mistakes could result in disqualification from the 1031 exchange benefits, leading to a substantial tax bill. Consult a professional accountant or real estate agent for guidance.
Know what is a 1031 Exchange, click here.
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Shirin Rezania Ramos | 858.345.0685 | www.shirinramos.com | Compass, DRE 0203379
