What is a 1031 Exchange?
What is a 1031 Exchange?
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties like kind and equal or greater value. It is a swap of one investment property for another that allows capital gains taxes to be deferred.
The main benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange allows you to defer capital gains tax, thus freeing more capital for investment in the replacement property. Keep in mind, though, that a 1031 exchange may require a comparatively high minimum investment and holding time. This makes these transactions more ideal for individuals with higher net worth. Due to their complexity, 1031 exchange transactions should be handled by professionals.
Depreciation is an essential concept for understanding the true benefits of a 1031 exchange. Depreciation is the percentage of the cost of an investment property that is written off every year, recognizing the effects of wear and tear. When a property is sold, capital gains taxes are calculated based on the property’s net-adjusted basis, which reflects the property’s original purchase price, plus capital improvements minus depreciation. If a property sells for more than its depreciated value, you may have to recapture the depreciation. That means the amount of depreciation will be included in your taxable income from the sale of the property.
Since the size of the depreciation recapture increases with time, you may be motivated to engage in a 1031 exchange to avoid the large increase in taxable income that depreciation recapture would cause later on. Depreciation recapture will be a factor to account for when calculating the value of any 1031 exchange transaction.
The 45-Day Rule is a very important part of 1031 exchanges. This 45-day limit is a hard and fast guideline. You can lose your opportunity at a Section 1031 Exchange if you’re one day late, and you’ll be obliged to pay income tax on depreciation recapture as well as capital gains taxes on the sale. This rule states that, within 45 days of the sale of your property, you must use all proceeds from that sale to purchase a new one for investment purposes. If not, then it will disqualify you from doing a 1031 exchange. You can only purchase one new investment property during this time, so choose carefully which one to buy. You cannot purchase the same type of investment property that you just sold in order for it to qualify as a 1031 exchange.
The 180-day rule is the amount of time you have to reinvest the proceeds from the sale of your property into a “like-kind” replacement property. If you don’t follow this rule, then you will not be able to defer your capital gains taxes
A 1031 tax exchange has many moving parts that real estate investors must understand before attempting its use. An exchange can only be made with like-kind properties, and Internal Revenue Service rules limit use with vacation properties. There are also tax implications and time frames that may be problematic.
The basic idea behind a 1031 exchange is that you’re allowed to trade one property for another without having to pay taxes on the sale. This can be a great way to move your money around without taking a big hit from the IRS.
Contact me below for more specific information on 1031 tax exchange properties in the Columbus real estate market.
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