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What are 1031 Exchanges?
1031 exchanges are named after section 1031 in the Internal Revenue Code (IRC), which states that investors can swap, or exchange, one property for another similar property without paying capital gains tax on the sale. Capital gains taxes usually take 15% to 20% of the sale, so being able to delay that tax can be a significant advantage. These exchanges require a third party, a qualified intermediary, to facilitate the exchange and put your funds in escrow during the transaction. You’ll only be able to access those funds to purchase your replacement property.
Technically, you could roll over capital gains until the end of your rental career, at which time you’d pay tax once on your long-term capital gains. This is one of the main 1031 exchange benefits. Using this method can help you reach your investment goals more quickly, but it’s important to know the potential risks as well.
What are the Benefits?
Why do a 1031 exchange?
The main benefit for investors is being able to defer capital gains tax indefinitely. It’s also advantageous to allow a third party, your qualified intermediary, to handle the intricacies of the exchange. They communicate with the title company, keep track of your records and funds, and prepare all the relevant asset documentation. Some of these responsibilities can be tedious and time-consuming for you as the investor, so letting someone else take charge is a welcome change.
Also, 1031 exchanges are a great way to diversify and improve your portfolio. Conducting this swap frees up more funds for you to acquire property for your portfolio that is of higher value. If you continue to trade for higher-value properties, it will be easier to hit your investment goals and look into investing in different kinds of properties or markets.
What are the Risks of a 1031 Exchange?
As with any business venture, there are pros and cons. Weighing the risks with the potential benefits of an investment decision always requires thorough research and plenty of thought. Here are some of the downsides of conducting a 1031 exchange.
The IRS Will Monitor You More Closely
Conducting 1031 exchanges requires strict adherence to rules and regulations set out by the IRS. You’ll need to file IRS form 8824 as well, in which you detail all the important facts about your exchange including what properties you swapped, when the exchange occurred, your qualified intermediary’s (QI) name and contact information, and the financial transaction details.
You must follow all the IRS’s rules as closely as possible to avoid consequences like penalties or audits.
Some Taxes May Still Apply
A 1031 exchange is not an automatic non-tax transaction. In certain circumstances, like if the mortgage on your new property is higher than the old mortgage, you could be taxed on the property sale.
Does 1031 exchange avoid state taxes? Most states allow you to avoid state tax as you would federal tax on a 1031 exchange. However, some states like California or Massachusetts do not allow for this tax deferral. Also, be careful when conducting an exchange in a participating state and selling it in a non-participating state, since you could end up having to pay tax in both states.
It’s important that you remain informed about the relevant real estate laws in your state before conducting a 1031 exchange.
Quick Turnaround Times
Due to close regulation from the IRS, investors only have 45 days from the time they sell their first property to find a replacement. Also, you only have 180 days to close on the replacement property; otherwise, the exchange will be unsuccessful. These short timeframes may be difficult or impractical for some landlords to follow.
Conclusion
Now that you have the important facts, you can use this article as a starting point to conduct further research into the topic. Weigh these pros and cons to decide if conducting a 1031 exchange is the best choice for your rental business. If you do the proper research and maintain reasonable expectations, conducting a 1031 exchange can be a very lucrative decision.