How Does a 1031 Tax Free Exchange Work?
If you already own or are planning to purchase an investment property, you should acquaint yourself with the 1031 exchange and how it works. For taxpayers, it provides many benefits for investors on every level.
A 1031 tax-deferred exchange, also referred to as a like-kind exchange, prevents an investor from needing to pay capital gains when selling a property. Once the sale takes place, investors have 45 days to identify the property that will replace the one they sold. The new property must be of equal or greater value. After that, the investor is given 180 days to close on the purchase of this property.
A 1031 exchange is for investment or business purposes only and stipulates both properties are located within the United States. They should also be similar though quality is not an issue.
Who is eligible for a 1031 tax exchange?
It is important to know what types of property sales are eligible for a 1031 tax exchange. Incorporated businesses, LLCs, partnerships, and trusts are all eligible tax-paying entities that can establish an exchange under Section 1031.
Who isn’t eligible for a 1031 tax exchange?
When it comes to personal property, selling one residential home for another would not constitute the use of a 1031 tax exchange. Other types of investments are also not eligible, including stocks, bonds, business inventory, securities, debt notes, certificates of trust, and interests in partnerships.
1031 tax exchange guidelines
Before a transaction meets the qualifications for a 1031 tax exchange, it must be contingent on the relinquishment of one property and acquisition of the other. The parties involved generally use exchange facilitation companies to assist in managing these types of deals to ensure that they meet all the requirements. Fortunately, the exchange does not need to occur at the same time but will need to happen within certain specified time frames.
The taxpayer has 45 days from the sale of the first property to identify properties that could possibly replace it. This identification must be delivered to the qualified selling agent or seller in written form and signed. The documentation should include details such as the property address and a supplied legal description.
The taxpayer must secure the replacement property and finalize the exchange no more than 180 days from either the sale of the first property or the deadline for the tax return for the year in which they sold the property.
Required paperwork for a 1031 tax exchange
It is vital to track each step in the process from when the first property is sold through the acquisition of the replacement property. The gain from the original sale of the first property must be well-documented, so if the replacement property is sold in the future, both will be taxed accordingly. The IRS requires 1031 exchanges to be tracked on Form 8824, which stipulates all the transaction details. The form also requests descriptions of both properties, acquisition and transfer dates, how the exchange parties are related, and the values of both properties. The declaration of the gain or loss on the first property is required as well as all cash received and any transaction liabilities that occur.
Finally, the property cost with additions and deductions of the first property should be included. IRS Publication 544 offers further details regarding the sale and nature of how investors should treat assets. Investors should investor speak to an accountant or attorney regarding a 1031 tax-free exchange to learn more about the rules and qualifications so that they will not have to pay capital gains on the relinquished property.