A 1031 exchange, also known as a Starker exchange, is a tax-deferred swap of one investment property for another. The process is named after Section 1031 of the Internal Revenue Code, which governs it. A 1031 exchange can help you defer capital gains taxes on the sale of real estate. This guide explains.
What is a 1031 Exchange?
A 1031 exchange is a tax-deferred swap of one investment property for another. The process may be able to help you defer paying taxes on the sale of a property.
To qualify for a 1031 exchange, you must meet the following requirements:
- You must exchange properties of “like kind.”
- The exchange must be for investment or business purposes only.
- You must complete the exchange within a certain time frame.
- You must use a qualified intermediary to facilitate the exchange.
- You cannot receive any cash or other “boot” in the exchange.
For the purposes of a 1031 exchange, property is considered “like-kind” if it is:
- Real property held for investment or use in a trade or business, and
- Like-kind to other real property.
For example, you could exchange a vacant lot for an office building, or an apartment complex for a strip mall.
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Investment or Business Property
To qualify for a 1031 exchange, the property that you are exchanging must be held for investment or use in a trade or business. This means that you cannot exchange your primary residence for another property.
You must complete a 1031 exchange within a certain time frame. You have 45 days from the date of the sale of your property to identify the property that you would like to purchase in the exchange. You have 180 days from the date of the sale of your property to complete the purchase of the replacement property.
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You must use a qualified intermediary to facilitate the exchange. A qualified intermediary is a neutral third party who holds the proceeds from the sale of your property and facilitates the purchase of the replacement property.
You cannot receive any cash or other “boot” in the exchange. This means that you cannot take any cash out of the deal. The exchange must be a true swap of one property for another.
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What Are the Drawbacks to a 1031 Exchange?
There are a few drawbacks to consider before entering into a 1031 exchange.
First, you may have to pay capital gains tax on the sale of your property if you do not find a replacement property within the 45-day identification period or the 180-day purchase period.
Second, you may have to pay a higher tax rate on the sale of your property if you have owned it for less than a year. Short-term capital gains are taxed at a higher rate than long-term capital gains.
Third, you may have to pay state and local taxes on the sale of your property, even if you defer paying federal taxes.
When Do You Pay Taxes on Your Capital Gains if You Use a 1031 Exchange?
You will not have to pay taxes on your capital gains until you sell the replacement property. At that point, you will be subject to capital gains tax on the sale. Of course, it may be possible to do another 1031 exchange at that point, further deferring the tax.
Note: You should absolutely consult with a financial professional and a tax professional before entering into a 1031 exchange, particularly if you’ve never made this type of investment before.
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