A 1031 Property exchange is a legal tax avoidance vehicle used in real estate investing. The number 1031 originates in the U.S. Internal Revenue Service (IRS) tax code from which it derives. According to this IRS tax code, the 1031 tax deferment may be applied when an investment property is sold and exchanged for a similar type of property.
The process for facilitating the exchange is conceptually fairly straightforward, however the process may not be. Several parties, financial instruments and events must occur before the exchange takes place. What's more in most probability the 1031 exchange will include at least a few of the following: Contracts, escrow accounts, negotiations, real estate agents/brokers, title companies, mortgage banks, accountant(s( and/or lawyer(s).
The step by step process
1. The property must be held/owned for less than 2 years and the exchange must take place within 180 days of releasing the first property.
2. Locate and hire a financial intermediary ex- mortgage bank with a real estate services division and/or execute the exchange through an Escrow account transfer
3. Determine the type of 1031 transfer. For example: Simultaneous exchange or delayed exchange.
4. If simultaneous and using an investment intermediary, the intermediary acquires both properties through an escrow account and exchanges them to the parties involved.
5. If a delayed exchange, the property is sold, however the sellers proceeds are held by the escrow until a new property is located. A replacement property must be found before 180 days and identified as such be the former seller.
6. An exchange contract must be created and agreed upon by all parties and the exchange takes place.
Properties invested in outside of the United States do not qualify for this tax break and unless a subsequent exchange occurs following the first exchange, tax may be incurred on the sale of the exchange property when the latter property is sold.
Delayed 1031 exchanges
In the instance of a delayed 1031 real estate exchange, the property investor first sells a home to a buyer with the intention of trading the property at a later date. This later date is usually either under 45 or 180 days.
During the transfer period the property's value is held through an escrow account until an exchange property is located. When a property is located, a written document informing the escrow manager must be filed. The process for buying the second property then begins which may include the several parties and financial instruments mentioned above.
Additional tips to consider
• Excess money acquired through or from factors relating to the exchange but not included in the exchange is subject to taxation.
• More than two properties may be involved in the exchange
• The exchanged investment property must adhere to the same ownership criteria as the original investment property Ex if held in joint tenancy, the newly exchanged property must also be held in joint tenancy by the same owners to qualify.
• An exchange property can be acquired before the original property is sold i.e. reverse 1031 exchange. While it is possible for an experienced and knowledgeable property investor to facilitate this process with as few collaborators as possible, it is probably advisable to utilize at least a real estate broker for their know how and experience in the 1031 process.
The tax benefits alone could pay for the Realtor's commission and save a lot of headache regarding contracts, locating suitable properties, setting up escrows, title searches etc. 1031 real estate exchanges involves specific tax code provisos. So it may be helpful to investigate the legal specifics and requirements of the tax code before initiating the exchange.
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