How to Defer Capital Gains With 1031 Exchange Rules 2021
Investment property owners have heard the term “1031 exchange,” but what is it and what is its significance?
It is understandable if you are unfamiliar with the subject since 1031 exchanges are common for investors selling investment properties. As you prepare to sell your investment property, you must know the ins and outs of the 1031 exchange rules 2021. This investment vehicle is one of the best ways to save money in taxes.
Taxes are rarely fun reading material, but these rules are a critical set of IRS regulations you must understand. Read on to find out more.
What is a 1031 Exchange?
The real estate industry is heavy with specialized terminology, so it’s vital to start with the basics.
A 1031 exchange is the exchange of two or more real estate properties under the tax code’s Section 1031. A simple definition of a 1031 exchange real estate for sale is you are swapping a property for another.
The Internal Revenue Service (IRS) Code Section 1031 allows entities and individuals to exchange real estate for productive use in trade but not for sale. Section 1.103 further states that there is no loss or gain recognized if the said property is held for business or in exchange for like-kind property.
Properties not considered under this rule are partnership interests, primary residences, stocks, notes, and securities. The exchange comes with strict limits and high legal fees. But it is worth it considering the extensive benefits you gain.
This also explains why 1031 is common for businesses moving up in buildings or selling their existing property for a larger facility with minimal taxes. While the entire process can be complex, it offers the best tax advantage for real estate investors.
Steps for a Successful Exchange Process
The 1031 exchange process involves several initial steps. Plus, you need to find a qualified intermediary before selling the property or taking any of the steps below.
Sell your property first. It’s advisable to have identified a potential replacement property at this point.
You do not need to close on the property immediately. If properties cannot be closed at the same time, the qualified intermediary holds the money. This means taxpayers do not receive money from the first property’s sale.
Formally identify the replacement property. 1031 exchange rules require that you do this within 45 days of completing the first property’s sale. It is best to have started the purchase process.
Complete the purchasing process for the replacement property, which includes making the payment and re-titling it. The intermediary holding the cash from the first sale sends it to the replacement property’s seller. The IRS treats the 1031 exchange as a swap and is complete after filling out an IRS form.
While you have 180 days to complete the transaction, you may have fewer days in some situations. For example, complete the process before filing tax returns before claiming a 1031 exchange. This means completing a 1031 exchange that has started the previous year before filing tax the following April.
Read more about these transactions on this 1031 FAQ.
Types of 1031 Exchanges
Simultaneous 1031 Exchange
An exchange that occurs on the same day. This was the 1031 exchange’s original form before the tax law was updated. In a two-party trade, the parties swap or exchange deeds. A three-party exchange involves an accommodating party to facilitate the exchange by transferring ownership between parties on the same day.
A Delayed 1031 Exchange
This is an exchange where you sell the property one day and receive the money but buy a property after a brief delay. If you do not purchase the replacement property within the set IRS time limits, you must pay capital gains on the proceeds.
An Improvement 1031 Exchange
An exchange that allows improving on the replacement property using the tax-deferred dollars from the money held by your qualified intermediary. However, you must meet the following requirements:
The entire exchange equity must be used as the down payment on a new property or for completing improvements.
The improvement or construction exchange involves a property you identified within 45 days of the 1031 exchange timeline.
A Reverse 1031 Exchange
If you get the replacement property before selling your first, this is a reverse exchange. This property is held by the exchange accommodation titleholder, such as a qualified intermediary. The title is then transferred to your name after selling the first property.
1031 Exchange Rules 2021 You Must Know
Here are critical 1031 exchange regulations and rules to be mindful of.
The Like-kind Property Rule
You can sell a rental home and purchase a small apartment building. Properties do not have to be in the same real estate sector. For example, you can sell an industrial building and invest the proceeds in NNN investment properties. However, domestic and international properties are not considered within the like-kind 1031 exchange rule.
The 200 Percent Rule
The identified replacement property should not be over 200 percent of the property you sold.
The 95 Percent Rule
You can ignore the 200 percent rule above and identify several potential replacement properties as you are purchasing 95 percent of the aggregate property values. For example, when you sell a property for $500,000, you can identify five properties worth $2,500,000 in total. However, you must purchase a minimum of $2,375,000 (or 95 percent) worth of the properties.
Exchange Rules for Primary Residences
IRS rarely allows for 1031 exchange rules primary residence transactions. This is because a home is a residential property and not used as an investment or held for business purposes.
Fix and Flip Properties Are Not Counted
A fix-and-flip property is regarded as a property held for sale and not for business or as a rental. You might count it as a 1031 exchange if you choose to rent it out for a short duration before selling it to investors.
1031 exchange rules 2021 allow real estate investors to build wealth faster by helping them avoid the hefty tax bill whenever they reinvest proceeds from property sales. This makes the rules a powerful tool for anyone looking to grow their portfolio.
Savings from a 1031 exchange are substantial enough to be used by real estate investors and businesses as a form of saving money. The biggest reason why many are not taking advantage of the rules is that they want to reduce their real estate exposure or cannot find suitable replacement properties in time. So, the next time you are considering a 1031 exchange, consider all the rules above for a successful process.