Section 1031 of the Internal Revenue Code underlines the rules of exchanging property held for investment or productive use. If you meet the requirements, you can acquire real estate through a like-kind exchange or 1031 exchange.
The strategy involves selling a property to acquire a similar one. In a 1031 exchange, the taxes can be deferred on the sale, or you can pay a limited amount.
There are several 1031 exchange approaches available depending on your goal and situation. Let's have a look at the types available to the United States taxpayers.
Simultaneous 1031 Exchange
A simultaneous exchange happens when you relinquish property and acquire the replacement property at the same time. The exchange has to happen simultaneously, and a small delay can lead to the disqualification of the 1031 benefits.
Simultaneous exchanges sometimes raise logistical issues making it hard to accomplish them. A common problem is when the properties being swapped are in different regions.
The exchanging parties can choose to swap deeds or invite an accommodating party to facilitate the exchange. Otherwise, they can hire a professional intermediary to structure everything on their behalf.
Delayed 1031 Exchange
This 1031 real estate exchange program is the most common. The investor relinquishes his or her property before acquiring the replacement property. In other words, you first transfer the property you want to give up before securing the desired replacement.
To initiate a delayed exchange, you have to market your property, find a buyer, and execute the sale and purchase agreement. Next, you need to hire an independent exchange intermediary to oversee the sale of the relinquished property. The third-party will hold the proceeds for a maximum of 180 days as you acquire a like-kind property.
The reason for the popularity of delayed exchange is that it gives the investor ample time to complete the transaction.
Reverse 1031 Exchange
A reverse 1031 exchange begins with buying a replacement property and ends with selling the relinquished property. The investor acquires the real estate via an exchange accommodation titleholder.
The taxpayer has to declare the real estate to offer as relinquished property within 45 days. After this period, the exchanger has 135 days to complete the sale and close the exchange.
Reverse exchange can raise the following challenges:
- Most banks won't fund reverse exchanges
- You cannot own the old and new properties at the same time
- Issues with tax for deed transfer may arise in some states
- Comparing equity from the old property with the new one can be a challenge
A reverse exchange could be an option to acquire an ideal property quickly for when there is a concern that the property will be off the market. A reverse exchange is also an option for when there is a need to close on the replacement property before you can sell your real estate.
Also termed as a construction exchange, improvement exchanges allows investors to upgrade the replacement property with the exchange equity. That is, the taxpayer can spend the deferred tax amount on improving the replacement property before closing the 1031 exchange.
This type of exchange is suitable for people who want to acquire a replacement property that doesn't match their needs. This real estate exchange allows you to make the necessary improvements on the real estate and include the construction as part of the exchange.
What Counts for 1031 Exchange Real Estate
Section 1031 is a provision for business and investment property only. Therefore, you cannot swap your home for an alternative primary residence. Real estate exchanges enable taxpayers to change their form of investment without cashing out or declaring a capital gain. You can swap properties without tax obligations until the time you decide to sell for cash.
It's essential to choose the real estate exchange model that suits you best. A minor mistake can annul 1031 privileges and lead to an unexpected sales tax. If you are interested in learning more, join the crowd at 1031 Crowdfunding today.