Real estate investors understand much of their long-term earning potential relies on their property values rising. Moving to sell a property after its value has risen will generally be an investment success, but it also triggers a capital gains tax based on the established tax basis of the asset. Thankfully, the Internal Revenue Code provides avenues for investors to defer those taxes.
U.S. Code § 1031 allows for the “exchange of real property held for productive use or investment” in order to trigger the nonrecognition of gain or loss from like exchanges of real estate. Many investors are aware of this practice, but it’s necessary to understand the limitations and exemptions within the code in order to effectively integrate it into your tax strategy.
The Like-Kind Exchange
A 1031 Exchange is often referred to as a “like-kind exchange.” This stems from the requirement that the acquired property be serving the same or similar purpose as the sold or exchanged property.
Both properties must be within the United States in order to qualify, meaning an exchange of real estate within the U.S. for real estate in a foreign country will trigger a gains tax. Outside of this limitation, the definition of “like-kind” has a relatively liberal application. Investors are permitted to apply a 1031 Exchange to exchange a piece of real estate occupied by a dwelling for an unoccupied plot of land or even exchange a business for a business as long as the purpose of both is similar.
1031 Exchange Timeline
To initiate the exchange, you will sell the original property – but you must never take possession of the cash paid for the property. Instead, the money from the sale must be held in escrow by a third party in order to facilitate the exchange for another property.
The first deadline comes 45 days after the sale takes place. By this point, the second property must be identified and designated in writing to the third party. Multiple properties can be designated by this point, but only one property will ultimately qualify and must be purchased.
The second and final deadline comes 180 days after the sale of the original property. By this point, the purchase of the exchanged property must be complete.
You can do this process in reverse by acquiring a property and later designating it as the exchanged property as long as you transfer the original property to a third party within 45 days and complete the sale of said original property within 180 days.
Limitations on Vacation Homes and Primary Residences
Since the enactment of Section 1031 of the Internal Revenue Code, the government has placed certain restrictions on what can be done with the exchanged properties. For example, you cannot exchange a business property for a property that you immediately convert into your primary residence. You also cannot exchange property for a home that you intend to use exclusively as a vacation home. Instead, you must rent out the new home in order to avoid disqualifying the initial 1031 Exchange.
The numerous pitfalls and loopholes of these exchanges necessitate an effective strategy. At The Law Offices of Tyler Q. Dahl, we have the expertise to navigate a 1031 Exchange and can ensure you get the most out of your hard-earned money. Contact us and avoid costly mistakes investors often make in these exchanges.
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