A 1031 exchange is named after Section 1031 of the Internal Revenue Code. It allows real estate investors to trade one investment property for another and avoid capital gains taxes in the process. Simply put, it’s like changing one investment property for another without instantly paying taxes on the profit.
Types of 1031 Exchanges
The five common types of 1031 exchange are:
- Delayed 1031 Exchange
- Reverse 1031 Exchange
- Improvement 1031 Exchange
- Partial 1031 Exchange
- Simultaneous 1031 Exchange
Delayed 1031 exchange:
The delayed 1031 exchange, is also known as the Straker exchange and it is the most common type of exchange. When people talk about the 1031 exchange, they mostly talk about the delayed 1031 exchange. In a delayed exchange, the investor contracts with a qualified intermediary (QI) to sell on their behalf.
Reverse 1031 exchange:
In a reverse 1031 exchange, an investor buys the replacement property first and then sells the abandoned property. Reverse 1031 exchange is the most expensive type of 1031 exchange. It’s often used in hot markets when investors have money on hand for an immediate purchase.
Improvement 1031 exchange:
In the Improvement 1031 exchange, also known as the build-to-suit 1031 exchange, an investor sells a property and uses the profit to purchase and renovate a replacement property. In most cases, the investor can find their ideal replacement property.
Partial 1031 exchange:
In a partial 1031 exchange, the replacement property has a lower value than the abandoned property. The leftover cash in a partial 1031 exchange is called “boot”, which is taxable. Because the boot is taxable, and tax benefits are the main advantage of a 1031 exchange.
Simultaneous 1031 exchange:
In a simultaneous 1031 exchange, you find an exact match for your own property to trade.
The two main types of simultaneous 1031 exchange are:
- A two-party trade in which two parties exchange deeds.
- A three-party exchange is when a third party “holds the title”, so the transaction is facilitated simultaneously.
1031: Exchange Rules for Dummies
Every 1031 exchange is different, but all are governed by standard rules.
1)Properties must be “like-kind”:
To qualify for a 1031 exchange, the abandoned property and the replacement property must be like-kind. A qualified intermediary can always guide you.
2)Property must be for productive use in trade or business:
For a property to qualify for a 1031 exchange, it must be for “productive use in a trade or business.” The property can’t be used for personal use.
3)You Must use some exchanger:
In order to complete a 1031 exchange successfully, the same person must sell the abandoned property and buy the replacement.
4)Exchange must be done within 180 days:
From the day you sell your abandoned property, you have 180 days to buy your replacement property.
Time limits
Once you begin a 1031 exchange, you only have a limited amount of time to complete the process. After you sell your abandoned property, you have a total of 180 days to finish your exchange. The first 45 days are your identification period, during which you need to identify the property you expect to change.
Why use a 1031 exchange?
1031 exchange is used for tax deferrals or also for growing investments.
Who can use the 1031 exchange strategy?
1031 Exchange is not just for big corporations; but individual investors, partnerships, and certain trusts can also benefit from this strategy.
The 1031 exchange is a valuable tool for growing investment and maximizing profits in the real estate market. The 1031 exchange is like a tax-saving trick for real investors. It lets you sell a property and buy a new one without paying any taxes. It’s essential to follow the guidelines set by the IRS (Internal Revenue Service) and work with professionals to handle such exchanges to ensure a smooth and lawful process.
