Investing in real estate has the added benefit of safeguarding against inflation and diversifying investors’ portfolios. If investors choose to move their capital from one real estate investment to another, doing so with a like kind exchange (1031 Deferred Tax Exchange) allow them to retain more of their investment. This kind of exchange allows them to postpone paying taxes on the amount gained from selling a property as long as they use it to purchase a different one that’s similar (‘like kind’ means they have some things in common like the purpose of the property and value). However, if you want to do this successfully, there are a few rules you need to be aware of — read on to find out more about how exactly a 1031 exchange works!
Table of Contents
What is a Like-Kind Exchange?
Investors can sell properties and use the money to buy another one without having to pay taxes on any profit they made from selling the first property. This kind of exchange is allowed under section 1031 of the Internal Revenue Code as long as the properties are being used for investment purposes, not primary residences. People who benefit from this law don’t have to pay taxes on their new property’s profit immediately – instead, they can wait until later to do so. Before the Tax Cuts and Jobs Act, it was also possible to make use of 1031 Exchanges when investing in things like patents, business equipment, artwork, and even certain kinds of trading stock; however, these days such benefits are restricted only to real estate transactions
Working Mechanisms of 1031 Exchange
The main advantage of like-kind exchange is how easy it is to understand. When someone sells a property (like one that they rent out or use for their business) and then uses the money from that sale to buy another one just like it, they do not have to pay any tax on the profit they made.
Rules of IRS
The IRS has specific rules about the types of investments that can be traded for one another. The investments both have to be properties; they can be different types like commercial versus residential, but not personal items like boats or vehicles. They new property is also required to be of equal or higher value.
What is not allowed by the IRS?
IRS doesn’t allow 1031 Exchange to sell a property in Canada and buy another in the US. Some assets don’t fall under 1031 Exchange, like properties for resale, flipped homes, personal residences, and land under development. The best part is that there is no restriction to the number of times investors exercise 1031 Exchange. However, there is a limit on how many properties can be rolled into one; no more than three properties can be exchanged for another.
How to Facilitate the 1031 Exchange?
Proper Channels
Apart from the IRS guidelines about 1031 Exchange, it’s essential to set up the right kind of platforms or channels to carry out the exchange. Getting help from a facilitator who can help with transactions where both properties are similar in nature is both useful for the investor, and mandatory by federal law. According to the IRS, it is not legal for someone to do 1031 Exchange by themselves.
Holding the Capital Gains
A qualified exchange facilitator acts as an intermediary who holds on to the capital gain funds for the investor as a part of an exchange, escrow, or trust agreement. Investors can’t appoint family members, relatives, or real estate brokers as intermediates for the like-kind exchange. The role of an exchange facilitator is to look after the sale of the old investment property, purchase a new one, and hold onto the capital gain of the sale in the trust. The process should be documented so that reporting to the IRS is precise. Investors will have to pay a fee amount to the facilitator for the service.
Other Charges or Fees
Investors should be aware of other fees like:
- Attorney’s fees
- Filing fees
- Commission fees (paid to the broker or agent)
- Title insurance fees
- Escrow charges
- Finder fees
Conclusion
The main advantage of like-kind exchange is that it allows investors to avoid capital gains tax, which can be anywhere from 10-30%! It’s important that investors follow IRS rules carefully and do not end up owing taxes they hadn’t planned on. If an investor isn’t familiar with how 1031 Exchanges work, it may be helpful to talk to someone who knows a lot about real estate, like an accredited investor, or a lawyer so they don’t make any unnecessary mistakes.
