What is a 1031 Exchange?
If you already own real estate and are looking to move to a more valuable place, it's something to consider... Under Section 1031 of the Internal Revenue Code (26 U.S.C. § 1031), the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.
In English? Actually, it's pretty simple.
Doing a 1031 Exchange allows you to avoid paying taxes on the home you sell AND the home you buy (until you eventually cash out... it's a lot like a 401k).
Let's use Mia as an example.
Mia buys her loft for $200k and sells it for $400k. With the money she's made (plus her $100k in savings), she can afford a $500k condo... if she can avoid paying taxes on her gains. If she doesn't use a 1031 Exchange, she owes capital gains taxes on her $200k profit, meaning she can't afford a $500k place. However, if she does use a 1031 Exchange, that $200k is hers to keep, and she can buy the $500k condo she has her eye on!
What's the catch?
The two main rules...
- The property you're buying must be identified within 45 days after the sale of your old home. This is called the Identification Period.
- You need to close on your new property within 180 days after selling your old home. This is called the Exchange Period.
You also need a Qualified Intermediary, a person whose job it is to hold your money after you sell and until you buy. Let's look at that in more detail below...
How do I pull off a 1031 Exchange?
Let's walk through a 1031 Exchange.
- Talk to a tax counsel or CPA. They can give you advice tailored to your situation.
- Sell your original property. Include a cooperation clause in the sales agreement. This says that the buyer knows you're doing a 1031 Exchange... and intends to cooperate (at no charge). Finding a Qualified Intermediary is up to the closing agent.
- Enter a 1031 Agreement with your Qualified Intermediary, according to IRS rules. You'll also sign an Amendment to Escrow, naming the Qualified Intermediary as the seller of your old place. Remember, you don't have to identify your new home yet... but you should be looking.
- Proceeds of the sale go to the Qualified Intermediary (so stay in touch with your QI). The money goes in a separate market account, and you now have 45 days to identify your new home (in writing).
- When you find a new home, identify it in writing to your Qualified Intermediary, the seller, or a real estate attorney. This written announcement must be signed by everyone who signed the Exchange Agreement... you, the QI, and so on.
- Close on your replacement home. Include another cooperation clause, which will show the Qualified Intermediary as the buyer. The deed, however, will show you as the buyer.
- The Qualified Intermediary puts Exchange funds (including growth proceeds) in escrow. Keep in touch, as they should send you info about your money soon.
- Come tax season, file an IRS form 8824, plus relevant state and local paperwork.
Any more questions? Let us answer them for you.