What are a 1031 Property Swap and How Can I Qualify?
If you own one property and want to replace it with another that better fits your needs, or if you have multiple properties and would like to combine them into one, you may qualify for a 1031 tax deferred exchange, also known as an IRC Section 1031 exchange. This type of exchange offers some major benefits, including the ability to trade one property for another without paying taxes on the capital gains from the sale of the first property.
A 1031 property swap is one way you can defer your capital gains taxes, but there are many moving parts that must be followed to do so successfully. Even there’re tax implications and time frames that are problematic. Anyhow, if you do qualify, it can be an effective strategy to help reduce the amount of capital gains taxes you pay on your real estate investment property or business assets as you sell one investment and buy another in the same year. But how do you know if you qualify?
Here’s what you need to know about this special tax rule so that you can decide if using it could save you money in the long run.
What Is Section 1031?
Apart from some technical details, Section 1031 of IRC deals about swapping or exchanging like-kind investment properties. Just like sales, a swap is also taxable but if it meets the requirements of 1031 exchange, you can defer the tax – either limited tax or no tax at all.
An important aspect about 1031 exchange is that there’s no limit on how frequently you can swap properties like this. It is possible to change the form of your investment without cashing out or having a capital gain. Your investment continues to grow with tax-deferred.
A 1031 property swap can be an excellent option if you’re looking to sell your current real estate investment property and reinvest the proceeds into another property considered as like-kind in the eyes of IRS. You can defer the capital gain taxes and there’s no limit on how frequently you can do so in the exchange. Anyhow, this tax break only works if you’re selling a business or investment property. It’s not for a residential property except formal principal residence under special conditions.
With 1031 Exchange, the sale of the property must be held in escrow by a third party so that means you cannot receive any capital even temporarily. However, you can have profit on each of the swap you make under 1031 exchange but you’ll only get cash once you ultimately sell it years later.
For long term capital gains the current rates for tax are around 15 to 20 percent but it depends on the income. For lower-income taxpayers it is 0% as of 2022.
1031 exchange is limited to properties that are in United States only and must be of like-kind. But that doesn’t mean you cannot swap an apartment building for raw land or ranch for a strip mall. The rules are liberal and you can even exchange one business for the other.
Because of profit trigger in depreciable property in the shape of depreciation recapture, special rules apply here. Such properties are taxed as ordinary income. Such cases generally arise when you swap a property that is on an improved land or has some special features. You can avoid such recapture by exchanging property on unimproved land. That’s where professionals like real estate agents and property consultants come handy. They guide you where you can do a 1031 exchange or where it is not applicable.
Although in ideal situations you might be able to find a property exactly matching with the conditions of your property and the owner is also willing to exchange. However, in majority of exchanges are delayed and so three-party or starker exchanges are involved. For such delayed exchanges you need an intermediary party who’s willing to hold the cash for you and buys a replacement property for you. For such cases you need to know about 45-day and 180-day rules.
The 45 days is the time period within which you need to designate the replacement property to the intermediary party. The declaration must be written and you need to specify the property for them to inquire. As per the IRS rules, you can designate three properties and you need to close on one of them.
180 days corresponds to the time frame within which you need to close on the new property from the time of sale of old property. So, in delayed exchange situation, you have 180 days to close on the new property.
So, it is important to keep track of the time once you’re involved in the sale of your property. And this time period runs concurrently that means, if you ‘re able to designate a property at 45 days, you only have 135 days to close on the new property.