Understanding Like-Kind Exchange for Real Estate

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Experienced real estate investors know that a 1031 Exchange is one of the best strategies for expanding their portfolios and increasing net worth. This method allows investors to sell properties and reinvest the proceeds in similar properties, deferring capital gains taxes. The tax benefits of the like-kind exchange, under Section 1031 of the Internal Revenue Code, can save investors 10-20% on gains; however, to maximize these benefits, investors must reinvest the sale proceeds guided by strict IRS rules. In this article, we’ll cover all the timelines and rules you need to know to get started on a 1031 tax deferred exchange.

Understanding the Definition of Like-Kind Exchange by the IRS

Under Section 1031 of the IRS (Internal Revenue Code), the like-kind exchange involves interchanging business or investment real estate properties of similar character, grade, and value. The procedure has been in practice since 1921 to aid tax avoidance of ongoing property investment and promote reinvestments. Real estate investors leverage the benefits of like-kind exchanges and enjoy tax deferrals on property sale profits.

Identifying the Eligible 1031 Exchange Properties

According to the IRS, a property is like-kind when it documents the same character or nature as the replaced property, even if the quality varies. The Internal Revenue Service considers properties for like kind exchange irrespective of their level of renovation or improvement. For instance, a real estate investor might exchange a larger apartment building for a small apartment project, office/commercial buildings, or vacant land. The Tax Cuts and Jobs Act of 2017 refrains personal and intangible properties for like-kind exchanges, like artwork, patents, collectibles, intellectual property, equipment, and machinery.

Real estate investors are liable for sales gain taxes if they don’t follow the 1031 Exchange rules. Further, the like-kind exchange documents stringent timelines and demands the assistance of a QI (Qualified Intermediary) to maintain an escrow account to hold the sale proceeds. the 1031 Exchange is incomplete without the presence of a qualified intermediary. The investors don’t hold on to the property sale amount. It is the responsibility of the QI to hold on to the amount, and investors use it when they reinvest in the replaced property.

Reviewing Different Types of Like-Kind Exchanges

The real estate investors use the following common 1031 Exchanges.

Delayed Exchange

It involves selling one old property and purchasing the replacement property within a specific timeframe.

Simultaneous or Delayed Exchange

It involves investors purchasing the replacement property at the same time as selling the existing/old property.

Delayed Reverse Exchange

The 1031 Exchange involves purchasing the replaced property before relinquishing the current or old property.

Delayed Build-to-Suit Exchange

The exchange involves replacing the existing property with a new property built-to-suit catering to the needs of the investors.

Delayed or Simultaneous Build-to-Suit Exchange

It involves purchasing the built-to-suit properties before selling the existing property.

Following the 1031 Exchange Rules

While considering the like kind exchange, real investors should have prior planning. The 1031 Exchange rules include:

  • To leverage most of the like-kind exchange, investors should recognize replacement properties that are equivalent or of equal value to the sold properties.
  • The Internal Revenue Service allows 45 days to identify the replacement of the sold property. Investors should look for equivalent replacement properties and wait to sell the relinquished property.
  • The investors should take the 180-day window to complete the replacement property purchase seriously. They should understand that the IRS includes weekends and Federal holidays in determining the 180-day window.

1031 Exchange involves the Mortgage Properties

1031 Exchange includes the like-kind exchange with current mortgage properties. The investors should ensure that the mortgage amount on the replacement property should be equal to or greater than the sold property. When there is a difference in the value, it is a boot and is taxable.

Conclusion

The like-kind exchange is a strategy to eliminate capital tax gains. One of the highlights of the 1031 Exchange is that real estate investors can defer tax capital gain payments permanently. Leveraging the benefits of the 1031 Exchange is similar to having loans from the Internal Revenue Service. Instead of paying taxes on the capital gains, investors utilize the sale proceeds and reinvest in replacement real estate property. Like-kind exchange helps real estate investors expand their portfolios and grow their net worth faster than other investment strategies.

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