You must make wise investments to get the most from your rental properties. You may then learn about 1031 Exchanges as you approach retirement, especially if your rental properties have substantially appreciated. The 1031 Exchange has its pitfalls, however. Explore the benefits, types, and types of properties that qualify for a 1031 Exchange.
1031 Basics
Knowing what a 1031 Exchange is and what types of 1031 Exchanges are available before you do one is essential. Section 1031 of the IRS tax code gives its name to a 1031 Exchange. Suppose the proceeds from the initial property are used to purchase another property (or properties) of like kind. In that case, capital gains on this investment property can be deferred.
You can conduct a 1031 exchange through several types of like-kind trades, including:
- Exchange delayed
- Exchange of information simultaneously
- Exchange of improvements
- Exchange of reversed roles
The sale of your current investment property cannot be used directly to fund a 1031 Exchange. An IRS-approved third party is required to hold the funds from the sale of the property and purchase the replacement property you have identified, often referred to as a “facilitator,” an “accommodator,” or a “qualified intermediary.” When you sell your current investment rental if you follow the 1031 Exchange process.
What is the purpose of a 1031 exchange?
If you want to sell your existing rental property, a 1031 exchange is a great investment tool. You may be able to delay the sale of your current rental property as long as you replace it with another like-kind investment property, and you can use all your equity towards the purchase of your new rental property after the sale of your current one.
One thousand thirty-one exchanges allow you to defer capital gains tax, and they don’t have a time limit on how long you can hold them. Even if you buy another property down the road, you can avoid capital gains tax if you do a 1031 Exchange. Taxes would only apply if you held the property and left it to your heirs once you passed away.
When nearing retirement, you can improve your rental property portfolio with a 1031 Exchange. Investing in a low-maintenance, high-cash-flow property may be the better option if you own a high-maintenance, low-cash-flow property. You will benefit from this because not only will you earn more rent each month, but you will also have lower repair costs, which will result in greater net cash flow and fewer management issues.
How do I qualify for a 1031 exchange?
In addition to knowing whether or not your property qualifies for a 1031 Exchange, you also need to know what kind of properties qualify as “like-kind.” Remember that only investment properties (such as rental properties) allow for a 1031 Exchange. A primary residence or a personal residence is not eligible. In addition, a 1031 Exchange is not applicable for properties you buy with the intent of reselling them soon, such as houses you plan to flip. You should hold your investment property for at least two tax years before applying for a 1031 Exchange.
Nonetheless, the IRS allows a relatively broad interpretation of what qualifies as “like kind.” For instance, you don’t need to sell your duplex and purchase another. It is possible to exchange a duplex for a single-family house or an office building for an apartment complex. Several properties can also be exchanged for one.
Reinvestment Criteria for 1031 Exchanges
Before performing a 1031 Exchange, you must know that 1) the property you purchase must be at least as expensive as your current investment property, and 2) your net proceeds must be re-invested 100%. You may still be eligible to complete a partial 1031 Exchange if you meet both requirements. This will allow you to defer some taxes otherwise owed.
Before you do a 1031 exchange, you should also know the following rules:
Selling your property does not bring you “boot” in cash. Boots are any cash you receive directly from a sale. Taxes must be paid on the boot received.
45-Day Period: Before you can do a 1031 Exchange, you must identify new properties to replace the rental property you sell during the 45 days. An expert can help facilitate this process, so working with one is crucial.
Your 180-day window begins when you sell your property and ends when you buy the replacement property you choose. Before you do a 1031 exchange, an expert can help you with what you need to know.
In addition to the above points, there are a few other things to consider when doing a 1031 Exchange and avoiding capital gains taxes.
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