In 1992, congress passed a law of particular interest to real estate investors, the 1031 exchange. According to the internal revenue code, this law encouraged real estate investment and stirred growth. It is defined as a law that allows investors to defer capital gains tax if they reinvest the proceeds into another venture of similar nature.
How Does A Transaction Qualify For 1031 Exchange?
For a transaction to become eligible, the investors have to ensure some rules are followed. They include the eligibility of the properties in question and the timelines for transfer.
- The cost of the replacement property must surpass or match that of the relinquished asset.
- The buying of the replacement asset must consume all the proceeds from the release of the previously owned property.
- The properties in question (the relinquished and replacement) need to be “like-kind.”
- The new asset must be found within 45 days and bought in 180 days.
What Are The Benefits Of The 1031 Exchange?
The most talked-about benefit must be the tax deferral. Real estate is the only industry that enjoys this kind of treatment, though. The benefits of doing it the 1031 exchange way cannot be ignored.
- You get to defer taxes like the federal capital gains tax and state capital gains tax.
- Cash flow is maximized through swift relinquishing and acquisition.
- The beneficiaries are exempted from inheritance and estate tax.
- Diversification can help minimize risk.
- Active management is not needed for real estate property.
What Are The Rules For This Type Of Investment?
If you are considering engaging in the process, you need to understand the rules. They are vital in capturing 1031 exchange basics.
- Before you undertake the process, you must first set up the exchange
- Ensure the properties are like-kind
- You must be the one to sell and acquire the new property (same person)
- You must within 45 days identify the replacement property
- The replacement property must be in your name within 180 days
What Are The Steps In A 1031 Exchange?
- Get a lawyer. Get hold of a legal expert to verify and oversee the sale of your property.
- Do a review. A tax expert will help with assessing the tax eligibility of the transaction. This is where you enter into legal binding to sell your property.
- Preparation of your property’s documents for sale. Your lawyer will prepare these documents for you. You will send them the sale contract for this. These documents are necessary for this process to become official. The lawyer will also help you document any money from the sale that is not utilized in the replacement. It is considered as income.
- The relinquishing begins. You, as the relinquishing party, will sign the exchange documents to release the property. The purchasing party must sign it too.
- Closure of the relinquishing. The financial proceeds are deposited into an escrow account set up by your lawyer. It can be through cash, cheque, or wire. Now the 45-day countdown automatically begins.
- The replacement begins. You have 45 days for identifying a property to replace the one you just let go of. You also have 180 days to close on the new property. You are also safe until your tax return is due.
- Prepare for purchase. You enter into a binding purchase agreement with the owner of the replacement property. Your lawyer must prepare these documents before the actual date.
- The actual exchange happens. Both the current seller and buyer sign the sale agreement, and the property changes hands. The exchanger signs the exchange documents while the seller signs the assignment documents.
- The replacement process is closed. Once you have settled on a convenient date, inform your lawyer. Request for funds and set up the money transfer date.
- Complete the exchange. At this stage, the exchange is considered complete. It, however, must meet these requirements.
- You, the exchanger, must use all the money from the sale on the replacement property.
- Your tax consultant needs to prepare an IRS file form 8824.
Real estate investment is encouraged by the government, judging by its willingness to retain this law. For an investor to benefit from it, however, they must meet specific rules and deadlines. You are advised to get in contact with reliable experts.