What is a 1031 Exchange: Basics That You Should Know

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By: Kapil Handa

Real estate investors generally need to pay tax on the profit, or capital gains, earned when they sell a property. However, US law[1] allows investors to defer capital gains taxes if they reinvest the sale’s proceeds into a similar property as part of a qualifying like-kind exchange. The gain from the sale is postponed, meaning that it is still taxed in a future year.

There is no limit to the number of 1031 exchanges you can do. Even if you make a profit on the sale of your property, your capital gains tax can be deferred until you finally remove your cash from the investment. At that time, you will only pay one long-term capital gains rate.

Which Properties are eligible for 1031 exchanges?  

Investment and business real estate properties are eligible for 1031 exchanges. Both the relinquished property you sell and the replacement property you buy must meet certain requirements.

Certain property like franchise licenses, equipment and furniture, inventory, and goodwill do not qualify for 1031 exchanges.

Qualified intermediary 

A qualified intermediary acts as a middleman between the seller and buyer. A qualified intermediary in a 1031 exchange transaction is a company or person that facilitates the transaction by holding the funds in the process. All the proceeds are kept by the intermediary who directly pays the seller of the replacement property.

Timeline 

The seller must find a new property within 45 days of closing the property and designate the replacement property in writing to the intermediary. You can specify up to three replacement properties if you eventually purchase one of the three. In limited circumstances, you may be able to designate more than three.

Next, the seller must close on the new property within 180 days of selling their original property.

Both the 45-day and the 180-day time periods run at the same time.

Reverse Exchange 

In a reverse exchange, you buy the property first and sell the existing property later. In this case the timeline starts from the day the property is first bought. For example, if you buy land on June 30, 2022, you will need to sell the existing property within 180 days from June 30.

cash and debt 

If you have cash left over after purchasing the replacement property, this amount will generally be taxed as a capital gain.

You must consider the debt you have on the relinquished property. If you use the proceeds from the sale to pay down a mortgage loan, that money will still be considered as income to you. Any debt taken for the replacement property should be equal to or greater than the debt paid off on the relinquished property.

reporting your 1031 exchange to the internal revenue service (irs)

Investors can use Form 8824 to report 1031 transactions. There is space to report both deferred and current gains.

Work with a trusted accounting professional to report a description of the properties exchanged, dates the properties were identified and transferred, value of like-kind and other property received, gain or loss on the sale of other (non-kind) property given up, cash received or paid, liabilities assumed or paid, the adjusted basis of like-kind property given up, and realized gains.

conclusion 

1031 exchanges can get complicated. If yours is not performed correctly, it can lead to additional taxes and penalties in the future. Please contact your trusted Chugh CPAS, LLP professional for help performing your 1031 exchange. 

 

[1] Internal Revenue Code (IRC) Section 1031.