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How Does a 1031 Tax Deferred Exchange Work? Tips for Staying Compliant

Are you an investor? If so, there are several reasons to opt for a 1031 exchange. It could be that you wish to avert paying any type of capital gain immediately. Perhaps you want to consolidate many small properties into an enormous investment. Maybe you have decided to shift all your investments from one place to a different locale.

Today, an increasing number of property managers find that their customers are shifting from misinformed landlords to rental real estate investors who have the correct strategies in place. All they are counting on are property management companies they hire to ensure they maximize their investments.

There is a need for property managers with ample know-how about the market who are equipped with the best investment strategies. They should also be aware of the compliance and tax laws, which include the rules for the 1031 exchange.

In this article, we will discuss what the 1031 exchange is all about and share a few rules that are essential to remember.

1031 Tax Deferred Exchange

Understanding the 1031 Exchange

Are you wondering how does a 1031 exchange work? With a 1031 exchange, you can reinvest the proceeds that you get from selling an investment or a business property in a like-kind investment. It is done so that you can defer the payment of capital gains tax for yourself as well as your owners. It is considered one of the famous domains in the federal tax code as it enables rental property or business real property owners to save a huge amount.

This brings about a benefit as well. Here is a like-kind exchange that enables you to defer paying the taxes after the sale of a property. You can do that by swapping the property for an equivalent property that someone else owns. That means the property you have access to in the like-kind exchange gets treated in such a way that it’s a continuation of the property that you had given up.

The outcome here is that you can defer the taxation of gain simply by shifting the basis of an old property to a new one.

Essential Tips to Keep in Mind

When you are opting for the 1031 exchange, it is necessary to keep a few rules in mind to get it right. They are:

1031 Exchanges Aren’t Compatible with Downsize Investments

One of the strict rules regarding a 1031 exchange is that the new investment property should have a greater or equal value to the property that has been sold. That aside, for a complete tax deferral, the overall proceeds of the sale should be used to buy the second property.

Let’s explain this with an example. For instance, when the initial sale totals $250,000, you cannot reinvest $200,000 in another property and get the $50,000 difference. Instead, it is necessary to include the $250,000 in your second transaction. If the property doesn’t have any greater or equal value, then the capital gains tax can be applied to the total capital gain.

Transactions Need to Be Structured

With every requirement that varies based on the circumstances, real estate investors ideally make use of five types of 1031 exchanges:

  • Delayed exchange, where a single property gets sold, and another property is purchased within the next 180-day period.
  • Simultaneous exchange, where both transactions take place at the same time.
  • Delayed reverse exchange, where the substitute property needs to get acquired before selling the original property.
  • Delayed ‘build-to-suit’ exchange, where the proceeds get used for financing a brand-new property to cater to the investor’s requirements.

Regardless of the selection a real estate investor makes, each of the rules are still applicable.

You Will Need Professional Help

It is necessary to make sure that everything is implemented according to the precise standards set by the IRS. And for that, there might be a need for you to get in touch with a 1031 facilitator or even a qualified intermediary (QI). When you have access to professional assistance, you can refrain from making any mistakes.

According to RealtyMogul, that way, you will have the guidance to stay compliant with the 45- and 180-day windows. You can choose and identify the correct properties to exchange and manage the funds between the transactions. It is necessary for the investor to finish the sale within 180 days of the sale.

In conclusion, it is necessary to keep the IRS updated concerning the exchange by filing Form 8824 besides the tax return. The form will list down the details of the properties included in the exchange process and offer a timeline of the transaction. It will also explain the parties that are included and keep correct documentation of all the financial aspects.

Sarah Williams
Sarah Williams

Sarah Williams is a blogger and writer who expresses her ideas and thoughts through her writings. She loves to get engaged with the readers who are seeking for informative contents on various niches over the internet. She is a featured blogger at various high authority blogs and magazines in which she shared her research and experience with the vast online community.

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