1031 is a powerful tool that will help an individual to save taxes after the sale of a property. It is a tax deferral program which allows the investors to sell a real estate property and then invest the funds that they have earned in another real estate property. The investor won’t be receiving cash at all, and this helps them in saving a good amount of money in the form of taxes. The entire transactions are authorized by 1031 of IRS code. Most of the people do not have a clear idea about this 1031 exchange. This article will help you in understanding the fundamentals of 1031 exchange and how can you invest in it.
What is 1031 Exchange?
Let’s consider a simple example- a person brought a property for $200,000, and when he thought of selling it, the price of the property was $400,000. If he traditionally sells the property, he will be liable to pay a good amount in the form of taxes, but if he exchanges the $400,000 worth property with another likewise one, he won’t be liable to pay tax on the exchange.
The Internal Revenue Code gives this exchange opportunity in the name of 1031 Exchange which is also termed as Starker loophole.
The similarities between the two properties don’t depend upon the quality. The revenue is the basis to understand whether to properties can be exchanged or not. The 1031 Exchange is strictly limited to business properties only; one cannot use this for domestic or personal properties.
Why Should One Consider this Exchange?
A property that is sold for gain is subjected to taxation. These taxes can be summed up quickly, and the owner of the property is liable to pay up to 37.5% of the amount in the form of taxes. But the 1031 exchange gives an option for the property owners to exchange their property with another one and avoid some of the taxes. It is a better way to save up some money. It allows better cash flow; easier management and one can exchange their property with the one that is present in their desired location. There are so many benefits of this 1031 exchange that made people interested in it.
Process Involved in 1031 Exchange
The entire 1031 exchange can be divided into two parts- before selling Relinquished Property, after selling Relinquished Property. The property that the taxpayer sells first is termed as Relinquished Property and the one he/she exchanges with is termed as Replacement Property.
- The 1031 Exchange usually starts with the regular sale agreement and purchase. The first thing that seller has to do is to get into a common sale agreement.
- Then they have to get into an agreement with the QI (qualified intermediary) for both exchange and escrow. The entire amount that they got from selling the property will go to the escrow now. The QI takes the ownership of property for some time, and the buyer is given the title of the property.
- From here the QI takes entire procedure into its hands.
- 45 Day Identification Window- The property owner has complete 45 calendar days after selling the first property to identify the like kind properties. This is the hard part because the taxpayer will need some time to determine the properties and know their worth. The taxpayer should pick four like kind of properties. In these 45 days, the properties that are chosen by the person are only considered for exchange. They cannot select new properties after 45 days.
- There is an exception here, and it is 200 rule. The taxpayer has a chance of selecting 4 or more properties that will be less than or equal to 200% of the price of selling property in exchange.
- 180 Day Purchase Window- The taxpayer should buy any one of the four properties by the end of the 180 days before closing the first deal which means he/she will be having 135 days left to make the purchase after the 45-day identification window.
- Now as you already identified the property and chose to exchange it with yours, the QI will start further procedure. The assignment of contract, mandatory notification of the assignment and information document will be prepared. The QI will take care of transferring the money from escrow to the seller and if any amount is left over it will be sent back to the taxpayer, and it will be taxed.
Some Pointers to Remember While Opting for 1031 Exchange
The entire 1031 Exchange has its pros and cons, so it is essential for you to go with a reliable and qualified intermediary. The intermediary plays a critical role in the entire process, and you should be smart while choosing one.
If the property that you have sold is under your name, then the property that you will buy in 1031 Exchange will also contain your name only. There is an exception for the single-member limited liable company (SMLLC). The property that is under the name of SMLLC can be sold, and the single owner can buy it under his name.
The LLC’s cannot do the same, and the title of both properties must be the same.
1031 Exchange Conclusion
The entire 131 Exchange is complicated and has so many rules that must be abided. A single mistake can throw entire deal under the bus, and it is vital to get professional help to take care of this process. If you understand clearly about the 1031 Exchange and the rules, regulations that are present in the process it will become more comfortable for you to proceed with. With the technology and professional help at a place, the utterly complicated 1031 Exchange will surely seem easier and simpler. All you have to do is read and understand the basics once, and you will be good to go.