The Basics of 1031 Property Exchanges

The Basics of 1031 Property Exchanges If you have business or investment property you'd like to sell, take a look at the 1031 exchange rules before doing so. These rules allow you to sell one property and purchase another of like kind, deferring any gains. Like kind means the property must be used for business or investment purposes, which could include apartment buildings, office buildings, industrial buildings, commercial buildings, rental housing units, raw land, farms, and ranches. You do not have to sell and buy the exact same type of property. Thus, you could sell undeveloped land and purchase a commercial building, deferring the gain. Or you could sell the building used in your business and purchase an apartment complex, again deferring the gain.

To defer the entire gain, the replacement property must be of greater value than the property you are selling, and all your equity must go back into the replacement property. Otherwise, part of the gain will be taxable. You do not have to purchase the new property from the same person who purchases your property. For the exchange to qualify as tax deferred, you must document your intention to exchange properties in the purchase agreement, not take constructive receipt of the sale proceeds, identify replacement properties within 45 days, and acquire the replacement property by the earlier of 180 days after the first sale's closing or the due date of your tax return, including extensions, for the year of the sale.

Typically, the most difficult part of a 1031 exchange is identifying the new property within the allotted time frame. Now, the Internal Revenue Service (IRS) allows the purchase of the new property before the sale of the original property.

If you want to sell your property and get out of real estate altogether, then a 1031 exchange would not be appropriate. However, if you have other goals, such as trading up or owning a different type of property, then a 1031 exchange may help you defer gains from the sale.

For instance, this tax rule can be used to help acquire a retirement home. Start out purchasing a small investment property. You can sell it at a later date and purchase a more expensive property, deferring the gains. You can continue this process until you eventually purchase your retirement home. However, before living in the home, you must first rent it out so the gain will be deferred. While there are no clear-cut rules on how long the home must be rented, the IRS has validated a two-year period. After that, you can move into your retirement home and use it as your principal residence. As long as you live in the home for two of the last five years before selling it, you could then sell the home and exclude up to $250,000 of gain if you are single and $500,000 of gain if you are married filing jointly.

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