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The 1031 exchange is an essential ingredient in the accumulation of wealth via real estate.
If you own a home or vacant land for investment the chances are it has appreciated in value.
You can use a 1031 exchange to trade up to a bigger property and increase your net worth.
Section 1031 of the U.S. Income Tax Code provides for the owner of investment property to sell that property
and purchase a replacement while deferring capital gains taxes. To qualify both the relinquished property
and the replacement property must be investment property or productive business property.
When both the relinquished property and the replacement property transfer concurrently it is called a
Simultaneous Exchange. This is not very common due to the difficulty of arranging concurrent closings.
1031 exchanges come in many variants, the most common being the Forward Delayed Exchange.
The investor first sells their property. Next they have 45 days to name up to three potential replacement
properties (or groups of properties). They have 180 days from the date of sale to complete the purchase of
a replacement investment property (or until the due date, including extensions, of the investors tax return
whichever occurs first). The IRS requires the use of a Qualified Intermediary (sometimes called a
Facilitator or Accommodator) to facilitate the tax-deferred exchange. You must take title to the new property
in exactly the same way as in the relinquished property. You must reinvest all of the cash proceeds from the
sale. During the time between the sale of the original property and the purchase of the replacement property
the proceeds of sale are kept in a trust fund account designated for this purpose.
Another variant is the Reverse Delayed Exchange. This would be used when the investor is
ready to close escrow on a replacement property but has not yet sold the original property. The timeframes
are the same as in the Forward Delayed Exchange: 45 days to name the relinquished property and 180 days
to completethe sale.
In an Improvement Exchange the replacement property may be improved or even built from the ground
up using tax deferred dollars from the sale of the relinquished property. The equity from the relinquished property
must all be spent within the 180 days and the value of the replacement property at the time the exchanger takes
title must exceed the value of the relinquished property. The improved property must be as identified within the
45 day period. In other words the identification of the replacement property must include specific details of the
improvements to be made. It is important to recognize that capital improvements are required, not simply repairs
needed to maintain the property in normal working order.
Safe Harbor is an IRS approved mechanism to shield the exchangor from taking posession of the proceeds
of sale. It requires a Qualified Intermediary to hold the funds until the exchange is completed.
Boot is cash or debt relief received by the exchangor. It does not invalidate the exchange but the boot
is taxable.
The rules of a 1031 Exchange are complex and must be followed completely. The information presented here
should be considered as an overview, consult with an expert before embarking upon your own exchange.
1031 exchange planning should be done before you take steps to buy or sell.
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