As a first-time investor, the ins and outs of a 1031 exchange can be overwhelming. But if you want to reap the benefits — and make sure your swap qualifies as tax-deferred — it’s important to follow the rules closely.
They vary depending on things like whether you’re selling commercial or residential property, where in the state you reside and how long you’ve held onto the property. Here are some main requirements for doing a 1031 exchange, also known as a like kind exchange, correctly so that you can move forward in investments with confidence.
Like-Kind Exchange Requirements
The 1031 Exchange should adhere to rules and regulations set by the IRS. Investors should cater to specific parameters and abide by the rules because failure to remain compliant results in 1031 Exchange disqualification and capital profit tax liabilities. Investors should familiarize themselves with like-kind exchange requirements.
Similar Property Exchange
The properties considered in the 1031 should qualify as similar. There is no rule that the property should be of an exact prototype, quality, or grade, like exchanging apartments for apartments. Instead, like-kind exchange implies an extensive array of real estate investments that qualify as long as they are in productive business, investment, or trade.
Including Business and Investment Properties
One of the critical requirements of the 1031 Exchange is that investors are not allowed to trade personal residences in the procedure. Business and investment properties qualify for 1031 Exchange because it is one such requirement that investors should comply with.
Equal or Greater Value Properties
Investors can avoid paying taxes, and equity and net market value should be equivalent to or more than the relinquished or old property. Most first-timers fail to comply with this requirement and pay tax on capital gains or profits.
The Same Taxpayer
The name of the property title and the tax return of the property sold should be the same as the title holder and tax return of the new property. The IRS requires this to avoid conflicts during annual tax deferments or tax payments, as the case may be.
Not Receiving Boot or Additional Value
The like-kind exchange shouldn’t encourage receiving boots or extra valuable assets that don’t qualify for the trade of properties. Boots, like property improvements or enhancements, cash, and debts, are a big no.
Reinvesting the Equity
When investors sell one property as a part of the exchange, they receive equity by selling. The investors should reinvest the entire equity into the new or replacement property. If they withdraw the equity in the middle of the exchange, investors pay tax for the parts that haven’t been reinvested.
No Transactions with Close Relationships
When investors sell and buy properties as part of the 1031 Exchange, they are not allowed to engage in transactions with close and personal relationships, such as family members and relatives. This is a critical requirement to maintain the validity of the exchange or transaction.
The above requirements are critical in determining the validity of a like-kind exchange. Investors should be careful and diligent in complying with the compliance regulations and rules to capitalize on or maximize the tax-deferment advantages.
Conducting the 1031 Exchange
Identifying the Property to Sell
Investors should ensure it is a business or investment property and doesn’t engage in a primary residence. The property should be appreciated so that investors can seek maximum tax benefits.
Engaging an Intermediary
Before selling the property, hiring an experienced intermediary is a must. It is compulsory as the IRS doesn’t allow the sellers to manage the capital between the sale and purchase or property transactions. The intermediary agent holds the fund during the period.
Listing the Property for Sale
After selling the property, the returns, excluding debt payoffs, go to the intermediary and not to the bank accounts. If investors fail to abide by this rule, they lose the tax-deferment payments of the 1031 Exchange.
Identifying Replacement Properties
Investors have 45 days from the date they sell the old property to identify at least three replacement or new properties. The value of the new properties must not exceed 200% of the old properties.
Purchasing the Replacement Property
Investors have 180 days from the date the old property is sold to purchase a new or replacement property. The intermediary transfers the funds to the replacement property seller after finalizing the deal.
Filing the Form 8824 with Annual Tax Returns
When investors file their annual tax returns for the 1031 exchange year, they should include Form 8824. It notifies the IRS of the 1031 Exchange and explains the process.
Conclusion
Executing the 1031 Exchange is daunting, given the overwhelming requirements and procedures. However, with a well-formulated approach and concise understanding, it is a seamless procedure. The IRS incorporates strict rules and requirements for the like-kind exchange to maintain the validity of the process. Complying with the rules helps investors reap the maximum benefits.
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