What do You Need to Know about 1031 Exchange Rules in 6 Easy Steps?

Investors who invest in real estate know that 1031 Exchanges offer tax strategies that can increase their portfolios and net worth. Let’s take a look at these six easy steps below to learn about the 1031 exchange five-year rule:

Learn What a 1031 Exchange Is According to the IRS

A like-kind exchange is when you exchange real property as an investment exclusively for like-kind property held for business purposes. The Internal Revenue Code had permitted like-kind sales since 1921 when Congress passed a law to encourage reinvestment and avoid taxation.

Find out if a property can be exchanged for 1031 tax benefits

It can qualify as like-kind property if it has the exact nature or character as the one being replaced, despite its quality differences. As long as the real estate has improved in some manner, the IRS considers it to be like-kind property. 

1031 Exchange Types: A Review

In general, real estate investors use five different types of 1031 exchanges. Here are a few:

1. One property will be disposed of – or relinquished – while acquiring another (or multiple) properties within the timeframe allowed.
2. A property exchange occurs when the current home is exchanged for a replacement home.
3. Purchasing the replacement property before relinquishing the current property is a delayed reverse exchange.
4. A delayed build-to-suit exchange replaced the current property with a new one built to suit the investor’s needs.
5. A build-to-suit exchange occurs before selling the current property or simultaneously with it.

Investors cannot receive proceeds from their previous property during the search for and purchase of a replacement property. A 1031 exchange intermediary, sometimes called an accommodator, holds funds in escrow until the replacement property is purchased.

1031 Exchange Rules You Should Follow

It is essential to plan when using a 1031 tax-deferred exchange. To follow a 1031 exchange, you must follow the following three rules:

1. Ideally, the replacement property should be at least as valuable as the sold property.
2. Establish that a replacement property will be available within 45 days so that one can be acquired
3. 5th Replacement: A Real-World Look at 1031 Exchanges

The following is an example of how a 1031 exchange works in reality. The following five assumptions will keep things simple:

1. There is a $1 million cost basis on the current property, which is a multifamily building
2. $2 million is the market value of the building
3. The property does not have a mortgage
4. The cost basis includes commissions and escrow fees that are payable with exchange funds
5. Property owners are subject to a 20% capital gains tax
6. There is a 180-day deadline for purchasing rent property

Conclusion

Real estate investors can build wealth through a 1031 exchange as a tax-deferred strategy. Even experienced investors need professional assistance because of the complex rules and many moving parts.