Are you planning to exchange out your investment property for another income-producing asset? In that case, you must know about Section 1031 of IRC that allows investors to defer capital gains taxes on exchanging like-kind properties. Yes, that’s true. As per the guidelines, an investor can defer up to 100% tax if they exchange an investment property for another. By like-kind properties, the IRS means income-producing assets. You can only reinvest the proceeds from an investment property into another income-producing asset. So, let’s start with how a 1031 Exchange works?
How Section 1031 function?
Though it isn’t too difficult to execute a 1031 Exchange, particularly if you’ve done it earlier as well, however, you should stick to the following steps in order to carry out the transaction smoothly –
- Hire a Qualified Intermediary and enter into a 1031 Exchange agreement along with him. Not to mention, the participation of a Qualified Intermediary in 1031 Exchanges is mandatory.
- Once you sign the agreement, the Qualified Intermediary will start looking for a buyer for your relinquished property.
- You must locate one or more replacement properties within 45 days after selling your old property. In the 1031 exchange language, it’s called the Identification Period. You must send a written identification of the replacement property, including the street address, to the IRS on or before the 45th day.
- After identifying the potential replacement property, all you need to do is acquire the same within 135 days. You’ll get 180 days in total for completing your exchange, which starts the day your relinquished property is sold. However, your 1031 Exchange will no longer be valid in case you fail to meet any of the deadlines.
- At last, you’ll have to submit form 8824 to the IRS at the time of filing taxes along with other required documents.
It’s evident that you’ll be able to complete your 1031 Exchange smoothly if you follow the above-mentioned steps. However, another thing that can certainly affect your 1031 Exchange is how you choose your 1031 investment property. As we had mentioned earlier, 1031 Exchanges don’t only provide the benefit of tax deferment but a lot more advantages as well, like diversification, leverage, relief from property management, etc.
However, once you’ve completed your 1031 Exchange and deferred capital gains taxes, you can only expect your replacement property to generate more revenue than what your relinquished property was generating. After all, why would anyone exchange their property for another if the replacement property doesn’t generate more revenue than the relinquished one?
Things you should consider while choosing your 1031 investment property?
- Make sure that the Fair Market Value (FMV) of the replacement property is equal to or greater than that of your relinquished property.
- In case the fair market value of the replacement property is less than that of the relinquished property, then that will result in ‘Boot,’ and you will have to pay the taxes on the profit. A Boot can be defined as the ‘cash or profit received by the investor’ in the exchange. Boot eliminates the opportunity of tax deferment.
- Another thing that you should take into account is the running debt on the replacement property. You must acquire a new property that has the same debt as on your old property.
- The location of your replacement property also plays a vital role. Using a 1031 Exchange, you can acquire a replacement property anywhere in the entire USA. You must look for properties that are built-in developed localities as it will increase the cash flow.
Apart from these, you should also pay attention to things like the property’s age, mortgaged loan on the property, capitalization rate, etc. You should only initiate a 1031 Exchange once you have examined all these aspects.
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