What is a 1031 Exchange?
According to Section 1031 of the Internal Revenue Code, on the sale of every Investment Property, the seller has to pay the Capital Gains tax levied on the procurement of that Replacement Property. To avoid paying the Capital Gains tax, investors can do a 1031 Exchange.
1031 Exchange is an ideal way in which investors can defer the ‘Capital Gains Tax’ by reinvesting the gains from their Relinquished Property into a certified Replacement Property.
What is the importance of 1031 Exchange?
The highest Capital Gains Tax paid is up to 37.5% of the Capital Gained from the Relinquished Property. To avoid making a massive investment without any returns, investors should choose the 1031 Exchange. The process is a little complicated to understand. Refer to the example given below to understand it in a better way.
- Relinquished Property Purchase Price : $700,000
- Relinquished Property Sale Price : $1,000,000
- Capital Gain: $300,000
- Profit of Approx : $100,000
- The Amount to purchase replacement property is $1,000,000 (after 1031 Exchange)
- Amount Left without 1031 Exchange is $900,000
More the price of Relinquished Property, more Capital Gain Tax is to be paid. To save this humongous amount of taxes while leasing your property and make more money through investing in real estate, it is vital to file 1031 Exchange.
What is the eligibility criterion for 1031 Exchange?
In this process of relinquishing your current property for a Replacement Property, one is voluntarily or involuntarily bound to pay the capital gains tax. Even if you are not residing on that property even then you are liable to pay the tax on property. Therefore, investors should make use of 1031 exchange within the stipulated period of 180 days to prevent paying the tax.
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What is the appropriate role of an investor in the 1031 Exchange process?
The role of an investor is to acquire a Replacement Property which is greater or equal to the value of the Relinquished Property. The investor is supposed to reinvest the net proceeds (equity) keeping in align with the rules and regulations of IRC.
1031 Exchange is a six-step process-
Investment Property on sale
The first step is to put your Investment Property on sale and simultaneously apply for 1031 exchange.
Choice of 1031 Exchange
The next step is to decide upon the type of 1031 Exchange and amount of money on which the process of relinquishing your property will begin.
Search for Replacement Property
After filing for 1031 Exchange, you need to upload all the details of your chosen Replacement Property within the 45 days of filing 1031 Exchange. Please note, make your choice wisely as once you upload your Replacement Property, you won’t be able to make any changes to it again.
Property under Contract
Now your property is ready to be bought. You need to inform the seller and buy your Replacement Property as an essential part of the exchange program.
After 180 days, 1031 Exchange will automatically shut your Replacement Property deal, and you can continue saving Capital Gains tax. You can follow the same process to reclaim tax on your other investment properties.
Notification to Qualified Intermediary (QI)
Exchanger will identify your Replacement Property within the first 45 days, and the information is sent to Qualified Intermediary (QI). The deal will be closed within 180 days via your chosen 1031 Exchange method and you will start getting your monetary gains.
A brief timeline of 1031 Exchange
Registration of the property for 1031 Exchange and finding a Replacement Property
From Day 0 to Day 45, the investor is bound to search and upload the details of his or her chosen Replacement Property
From 45 days to 180 days, Exchanger is supposed to close the deal and you are deferred from paying capital gains tax on your property.
What are the advantages of 1031 Exchange?
Along with selling your property, you can make a steady income in the form of tax returns from your property.
No restriction to property type
Under 1031 Exchange, you can buy any Like-Kind Property. It can either be residential or commercial.
Secure Property Management
You can easily exchange your demanding property with a property with an easily manageable property.
1031 exchange enables you to make property exchange in a different state as well.
Hassle free Consolidation
You can easily exchange many properties for a single property which is not only advantageous but also manageable.
Deferring from Capital Gains Tax
You can save up to 37.5% funds from the property by filing 1031 Exchange.
What are the methods of 1031 Exchange?
Delaware Statutory Trusts
Also known as DSTs, Delaware Statutory Trusts is a 1031 Exchange type ideal for people seeking replacement possessions. DST provides 6-7 percent returns every month without being burdened by the management responsibilities of the Replacement Property. The lock-in period of DST is ten years. Please note for DST; you need to have a security license.
Triple Net Lease
Triple Net lease is also known as NNN or Net Net Net. This form of 1031 Exchange provides zero management responsibilities as well as monthly payments in the form of rent paid by tenants according to lease. The properties owned under NNN 1031 exchange are available for lease for a span of 25 years.
Real Estate Investment Trust
Real Estate Investment Trust is commonly known as REIT. Under the REIT 1031 Exchange, many investors collect their properties in one place and file exchange. Multiple taxpayers use REIT 1031 Exchange. The process of REIT involves acquiring, possessing and managing multiple commercial possessions from a profit point of view
Tenants in Common
Tenants in Common or TIC 1031 exchange allows you to choose your Replacement Property at any location suitable to your needs. You can invest via any form of Like-Kind Property irrespective of it being a hotel, warehouse, storage units, sanatorium or an agency complex.
This form of 1031 Exchange enables investors to defer Capital Gains Tax levied on sale and purchase of Like-Kind Properties. Be it a residential property or a commercial; investors can easily prevent paying the taxes.