A 1031 exchange can be a great way to defer taxes and increase your overall cash flow. A well-executed 1031 exchange can provide you a way to legally defer paying taxes for investment gains made by selling a qualified property. The key here is that you have to purchase another property that is “like-kind” for investment purposes. Essentially, you are exchanging properties.
If you are wondering if a 1031 exchange might be right for you, keep reading for some important things to know regarding 1031 exchange properties.
Properties Must Be “Like-Kind”
You are only able to delay paying taxes on gains if you reinvest the proceeds into a property that is considered “like-kind.” This means that you’ll have to reinvest into a property that is of the same nature, class, or character. You can’t use the proceeds to reinvest into a boat, for example. Typically, most real-estate will be considered “like-kind” towards other real estates, except for real estate that is located outside the U.S.
Properties Must Be “Productive” or an Investment
Both properties involved in a 1031 exchange must be for one of two purposes:
- As an investment that either generates income or is expected to increase in value
- As a productive and active asset used in a trade or business
This prevents people from selling their primary residence and buying another home to live in while deferring taxes. You may be able to qualify for a 1031 exchange with a rental property, but there are specific rules that must be followed. Additionally, 1031 exchanges are not for people who happen to be in the business of flipping real estate.
Properties Must Be Identified Quickly
In order for you to take advantage of the tax deference, you must meet two different time limits. These limits are unable to be extended, and failure to meet them will result in your entire gain becoming taxable.
The first limit is called the identification period and it’s set 45 days from the date that you sell the relinquished property. Within these 45 days, you’ll need to find one or more properties that you identify and intend to buy.
The second time limit is called the exchange period and is set 180 days after the sale of the relinquished property. What this means is that from the day you sell your first property, you will have 45 days to identify a new one. Then you have an additional 135 days to actually buy or acquire the property. Meaning the whole exchange process should be completed within that 180-day time frame.
1031 exchanges can be a great way to delay the payment of capital gains. Keep in mind that these taxes are only deferred and not eliminated.