Every time you sell real estate, the IRS expects you to pay a tax called capital gains. However, if you want to sell your property in order to buy a second piece of real estate that is better than the one you already have, you can defer the capital gains tax if you follow IRS 1031 exchange rules.
The 1031 exchange, also known as the tax deferred exchange, allows you to sell your “qualified” property in order to buy another property that is also “qualified”. The whole transaction also has to be made within a specific time frame, which is 180 days. Tax is deferred because the transaction is treated as an exchange and not a simple sale. In order that the properties become “qualified”, the acquired property should be more expensive than the price of the relinquished property. That means that all the proceeds from the sale of the relinquished property should go towards the buying of the acquired property, and you have to put out some more cash or acquire more debt. If there is some money left over from the sale of the relinquished property after buying the acquired property, the transaction will not be eligible for tax deferral because you made a profit.
The whole transaction will also have to go through a “qualified intermediary (QI)” and not your sales agent. The qualified intermediary should be a company or organization that deals full time in facilitating 1031 exchanges. The qualified intermediary also should have a relationship with you, familiar or business, and should be an organization whose only contract with you is to serve as a qualified intermediary.
There is also a timeline that has to be followed in the 1031 exchange. The property to be acquired should be identified within 45 days of the sale of the relinquished property. You can choose and identify more than one property. The acquisition of the new property also has to be made within 180 days of the sale of the relinquished property. The time line should be followed strictly even if the 45th day and the 180th day fall on a Saturday, Sunday, or legal holiday.
All these rules have to be followed strictly for your transaction to qualify for the 1031 exchange. If you want to improve the value of your investments, this is a great way to do it in terms of financial planning. You also will save a lot by not paying taxes.
There is also the 1035 exchange, but this exchange does not involve real estate, it mainly involves annuities, endowments, and life insurance.
Photo by djshaw **Courtesy of sxc.hu
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