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What is a 1031 Exchange?
A 1031 tax-deferred exchange allows you to preserve your wealth through reinvestment in 'like-kind' assets. It's a powerful tool'a tool that can work to your financial advantage. When you sell your interest in investment property, you may incur federal capital gains taxes and, in some states, state taxes as well. Your attorney, tax advisor, or real estate professional may suggest a tax-deferred exchange under Section 1031 of the Internal Revenue Code. A tax-deferred exchange allows you to dispose of investment properties and acquire 'like-kind' properties while deferring federal capital gains taxes. Most states with a capital gain tax offer a similar tax advantage, too.
Bottom line: a tax-deferred exchange allows you to reinvest sales proceeds that would otherwise be paid to the government in the form of taxes. Section 1031 of the Internal Revenue Code provides a remarkable opportunity to build wealth by deferring taxes. Within carefully defined limits, this section of the Code permits you to carry forward the gains you have made on one property into another one, deferring capital gains taxes and, thus, allowing the full use of your equity in the acquisition. An exchange can be much more advantageous than the sale of one property and the purchase of another.
The Concept of "Like-Kind"
Any real or personal property can be exchanged, provided it is held 'for productive use in a trade of business' or 'for investment' and is exchanged for property of 'like-kind' that will also be held for one of these same purposes. 'Like-kind' does not mean 'exactly the same,' particularly with the exchange of real property. A single-family rental unit, for example, may be exchanged for other real property like a warehouse, retail center, office building, farm property, or even a leasehold interest in real estate of 30 years or more. Most real property is considered 'like-kind' to other real property. 'Like-kind' limitations on personal property are more restrictive. Essentially, items of personal property must be classified similarly under certain government accounting classifications.The general requirements for a tax-deferred exchange are clear and simple:
Identification PeriodThe replacement property must be identified within 45 days of the transfer of the first relinquished property.
Exchange PeriodThe acquisition of your replacement property must be completed by the earlier of (1) 180 days of the transfer of your first relinquished property or (2) the due date of filing your federal income tax return for the year in which you transferred the first relinquished property, including extensions.
Fully Deferred ExchangesFor your exchange to be fully tax-deferred, your replacement property must be equal to or greater in value and equity than your relinquished property. The debt on your replacement property must also be equal to or greater than the debt on your relinquished property, unless cash is added to offset debt. You may identify replacement property according to the following rules:
3-Property RuleThree properties, regardless of value, or
200 Percent RuleAny number of properties, as long as their combined fair market value does not exceed twice the value of the relinquished property, or
95 Percent RuleAny number of properties, regardless of their combined fair market value, as long as you acquire 95 percent or more of the total value of such properties.
The Qualified 1031 IntermediaryIn order to successfully execute the strict requirements of a 1031 Exchange, individuals wanting to do an exchange must do so through what's known as a "Qualified Intermediary" (such as First American Exchange Company or IPX,Inc). To facilitate your 1031 exchange, your qualifed intermediary actually acquires the property you are selling and transfers it to the buyer of your property.
The intermediary then takes possession of the proceeds from the transaction and then uses the same proceeds to acquire a replacement property on your behalf (from the seller of the replacement property you wish to buy--or in this case, "exchange"). After the intermediary successfully makes the exchange on your behalf,they transfer title (or ownership)back to you in your name-- thereby completing the exchange so that you don't end up paying taxes through the process of buying and selling your investment properties.
Call me at 805 235 3221 or email me at paul@slohomes4sale.com I'll be happy to help you find a Qualified Intermediary-- and to answer as many 1031-related questions as possible.
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