For those in the dark regarding a 1031 exchange, but have heard about it and are curious, I have shed some light here. I have attempted to elaborate in simple terms the benefits of a 1031 exchange to make it easy to understand irrespective of your background.
First and foremost, the purpose of a 1031 exchange should be understood. The basic idea is to defer taxes, namely capital gains tax, from sale of property whose profits you want to directly invest into a second property. This is done to avoid loss of equity during transition from a property to another one.
Now that the concept is clear, let's try to understand how it works. Firstly, law requires you to have a QI or Qualified Intermediary, which is an independent third party. These people serve the purpose of holding profits obtained from sale of a property until it is invested into another property.
Next, there are certain rules to be considered regarding what qualifies for a 1031 exchange. Firstly, the only thing involved here is investment properties. This can, however, include single family rental properties, multi-family rental properties, storage facilities, office buildings, retail shopping centers, raw land, industrial facilities, etc.
Secondly, two like properties have to be involved to qualify for 1031 exchange. The value or conditions of the properties are immaterial, but what is important is that they be of similar nature. Also, the properties should be utilized for investment purposes or other productive purposes like in business or trade.
The IRS has laid down many other rules for 1031 exchange, due to which they prefer anyone to hire a qualified professional for this purpose. Some general guidelines which are easy to understand are presented below. They might guide you in deciding and planning your investments.
- The new property should be of higher or equal value as compared to the property that is being sold.
- The new property should also have equity higher than or equal to the property being sold.
- Debt on the new property should be equal to or higher than debt on the existing property about to be sold.
- The new property must be acquired by using ALL net profits from sale of the existing property.
Timeline rules are also quite strict in case of a 1031 exchange. The new property must be identified by the investor within 45 days of the closure of old property. There are guidelines pertaining to identification, too. Secondly, the person should close on the newly identified property within 180 days from the old property's closing date.