January 27, 2023

If you’re considering a 1031 exchange, it’s essential to understand the timelines and rules involved. This article will discuss the basics of 1031 exchanges to determine if this type of transaction is right for you.

Keep in mind that specific requirements must be met to qualify for a 1031 exchange, so it’s important to consult with an experienced professional before making any decisions.

What is a 1031 Exchange

A 1031 exchange originally comes from Section 1031 of the Internal Revenue Code (IRC) of the United States. This exchange exempts investors from incurring capital gains taxes when they sell a rental property and reinvest the earnings within specific time limitations in a property or properties of the same sort and equal or higher value.

An Internal Revenue Code section allows for the deferral of capital gain taxes on the exchange of like-kind property. If you sell an investment property and reinvest the proceeds into a new property, you can postpone paying taxes on the gain. The replacement property must be “like-kind,” meaning it must be used for business or investment purposes.

The most common type of exchange is a real estate exchange, in which an investor sells a property and reinvests the proceeds into another property. However, exchanges can also be used to exchange other types of assets, such as businesses, aircraft, and art.

There are strict deadlines that must be met to qualify for an exchange, so it’s important to work with a qualified intermediary who can help ensure that the transaction is completed correctly.

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1031 Exchange Timeline 2022

One of the benefits of a like-kind exchange is that it allows you to defer paying taxes on the gain from the sale of your property. To qualify for this tax treatment, you must follow the timelines and rules set forth by the IRS. These rules include meeting certain deadlines.

The first deadline is that you must identify potential replacement real estate within 45 days after the sale of your original property. This identification must be made in writing and provided to the qualified intermediary. The identification can include up to three properties, regardless of their value.

The second deadline is that you must purchase one of the chosen properties within 180 days after the sale of your original property. If you do not purchase a property within this time frame, you will not be eligible for the like-kind exchange and will have to pay taxes on the gain from the sale of your original property.

1031 Exchange Rules for 2022

Property investors must adhere to the following guidelines to delay paying capital gains tax when undertaking an exchange under IRC Section 1031:

Investment Property

Both the relinquished (sold) and replacement properties must be of a similar kind and be utilized for business or investment objectives. For instance, you may trade an office complex and exchange it for single-family rental houses, or you can trade land and acquire a multifamily property.

However, a primary residence is not similar since it is not mainly intended as an investment. Moreover, property inside the United States is not like-kind to property outside the United States.

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Same Taxpayer

Individuals and companies with investment properties are eligible for a tax-deferred 1031 exchange. Thus, a Section 1031 exchange may be undertaken by the following:

  • a natural person
  • S corporation
  • C corporation
  • Partnership
  • Trust
  • Limited Liability Company (LLC)
  • Any other tax-paying organization

But, the identical taxpayer name should be used when selling and purchasing property in a 1031 exchange. The IRS views a 1031 exchange as a continuance of ownership, even though the individual properties are distinct.

Higher Or Equal Value

The 1031 exchange should not result in a profit for the investor. Thus the replacement estate should be of equal or higher value than the relinquished asset. Additionally, the mortgage amount of the replacement property must be equal to or higher than the mortgage balance of the property being replaced. For instance, if the mortgage sum on the surrendered property is $200,000, the replacement property must likewise be funded with a loan of a minimum of $200,000.

No Boot

The term “boot” refers to the situation that arises when the price of the replacement property is lower than the amount of the property that was given up. Because the profit from the sale of the property did not cover the whole cost of the property that was acquired in its stead, the difference is considered a capital gain for the purposes of taxation in the year that the exchange was executed.

No Touching Of Money

Investors use a qualified intermediary to take the selling profits from the relinquished property and transfer them to the seller of the new property after escrow closes. Capital gains tax will be levied on the whole amount investors receive once they seize control of the sales profits. Hence, there is no touching the money between the two parties.

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The Role of Qualified Intermediaries

A qualified intermediary is an individual or business that commits to assist a 1031 exchange by keeping the money until they are given to the vendor of the replacement property. They cannot have any other official links to the parties involved in the property exchange.

According to Section 1031, all profits from the sale of a property are taxed. Therefore, the revenues of the transaction must be handed to a qualified intermediary instead of the property seller. The qualified intermediary then transfers them to the seller.

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Tax Implications Of A 1031 Exchange

Undertaking a 1031 exchange may have tax implications. Take into account the following:

  • Following an exchange, remaining cash, sometimes known as “boot,” may generate capital gains.
  • You may be taxed if the mortgage on the property you’re purchasing is less than the mortgage on the property you’re selling.
  • If the sale of the surrendered property does not go through, you will be taxed on it.
  • If you execute several 1031 exchanges over the course of several years, you may incur hundreds or thousands of dollars in deferred profits, so raising your tax obligation.

Bottom Line

Although some specific requirements must be met to qualify for a 1031 exchange, this type of transaction can be a great way to defer capital gains taxes and reinvest your proceeds into another property. If you’re thinking about doing a 1031 exchange, it’s important to consult with an experienced professional who can help you navigate the process and meet all of the necessary deadlines.