What Is A 1031 Exchange In Plain English?
Many people have no idea what a 1031 exchange is, but hear of it when it comes time to sell off property. This article is intended for those people. I have written this in the simplest way that I can so that it can be understood by all.
It is important to understand the purpose behind a 1031 exchange in order to understand it. The point of using 1031 exchange is to defer the immediate taxes on the proceeds gained from the sale of property. This can be done legally if you plan to immediately reinvest those proceeds into another piece of property. The reason you would want to do this is so that you do not lose any portion of the equity you have built up in a property simply because you essentially exchanged one property for another.
So now that you understand the purpose, you should understand a little bit about how it works. First, you are required by law to have what is called a QI. This is a 3rd party that is independent and serves as a Qualified Intermediary (hence QI). They are there to hold the profits from the sale of the first property that you sale until you invest it into another property(s).
Next, there are some guidelines about what qualifies for a 1031 exchange. 1031 exchanges involve property. Generally, this would refer to single family rental units, multi-family rental units, office buildings, storage facilities, raw land, retail shopping centers, and industrial facilities. There are some things that are excluded from 1031 exchanges and you can find those by asking a QI about them.
Second, the major qualifier is that the properties are of like kind. Like kind refers to the similar nature or characters of properties, not the grade or the quality. They (referring to all properties involved) also must also be held for productive use in trade or business. Another viable option is if they are held for investment purposes.
There are a lot of other specific rules that the IRS has for this kind of exchange and that is likely why they require anyone who does this to use a qualified professional trained in this. However, there are some general guidelines that you should be able to understand and may help guide you in your decisions on your plans for investments if you are looking into this.
1- The value of the new property must be of equal or greater value than the one you are selling. 2- The equity of the new property must also be of equal or greater value than the one you are selling. 3- The debt on the new property must be equal or greater to the debt on the property that you are selling. 4- ALL of the net profits from the property that you are selling must be used to acquire the new property.
Along with these guidelines, there are some timeline issues that you should be aware of as well. First, you must identify a replacement property by the 45th calendar day from the time of the closing on the old property. (There are even guidelines about how you identify property, but that is for another time) Second, you must close on the replacement property by the 180th calendar day from the time of the closing on the old property. Hopefully this helps everyone understand a little more about 1031 exchanges and how they work. Please consult a professional when you get started doing a 1031 exchange.
