Hi! I'm an investor like you, preparing for the sale of an investment property. Taxes are what I like to refer to as "guaranteed losses," and I attempt to defer or eliminate them whenever possible. Let's discuss one of the best ways to legally defer the capital gains taxes that would otherwise be due on the sale of investment property. It's called a "1031 exchange."
What is a 1031 exchange? In this infographic you will learn how to defer your capital gains taxes utilizing a 1031 exchange, what kinds of properties qualify for 1031, what the basic 1031 rules and time limits are, and how to benefit your heirs by stepping up your basis.
TRADITIONAL SALE VS 1031 EXCHANGE
I plan to sell my investment property, but the taxes may exceed 20-35% of the capital gain.
If I reinvest the proceeds from the sale of my investment property using a 1031 exchange, I can defer all of those taxes and keep 100% of my capital working for me!
GENERAL 1031 EXCHANGE RULES
In a 1031 exchange, the replacement property must be "like kind" to the relinquished property. The difference in type, grade, and quality does not matter. Generally, any real estate held for business or investment purposes in the U.S. or U.S. Virgin Islands is considered "like kind." For example, an investor can exchange a commercial property for another, or a residential rental property for a commercial property, and vice versa.
My own personal residence and vacation home are not considered to be of "like kind" to any real estate held for investment or business purposes, and they cannot be used in a 1031 exchange. (There are other tax shelters that apply to the sale of one's personal residences.)
The value of the replacement property must be equal to or greater than the value of the relinquished property to obtain a full deferral. I would have to pay the capital gains taxes on any of the proceeds that weren't reinvested.
The ownership title for the replacement property must be identical to the title for the relinquished property.
1031 EXCHANGE OVERVIEW
STEP 1. DECIDE TO EXCHANGE
I need to sell my investment property, but I don't want to pay the capital gains taxes, so I am going to complete a 1031 exchange.
STEP 2. SELL PROPERTY
When I relinquish my property, I can't take receipt of the proceeds, so I will have the funds held by a Qualified Intermediary.
STEP 3. IDENTIFY PROPERTY
Once the Qualified Intermediary holds the proceeds from the sale, I'll work with my broker or investment advisor to identify suitable replacement properties.
STEP 4. BUY PROPERTY
Once I decide which of the identified properties to acquire, the Qualified Intermediary will forward the funds for the closing.
THE 1031 EXCHANGE TIMELINE
Once I close escrow on the sale of my investment or business property, the countdown starts. I have 45 calendar days to identify possible replacement properties and 180 total calendar days to close escrow on my replacement property. The countdown includes weekends and holidays. I have to be careful because the IRS is very strict about these deadlines.
PROPERTY IDENTIFICATION RULES
I may identify up to three potential replacement properties and purchase any (or all) of them, regardless of their total value, to complete my exchange.
If I'd rather, I may identify more than three potential replacement properties if their total value does not exceed 200% of the value of my relinquished property. I may purchase as many of the identified properties as I want.
If neither of the other two rules suits my needs, I may identify any number of potential replacement properties regardless of their total value so long as I purchase 95% of the total value of all of the properties identified.
BENEFITING YOUR HEIRS
I can continue to defer my capital gains taxes using the 1031 exchange process until it becomes time to pass my assets on to my heirs. When that happens, the basis by which the capital gains are determined steps up to the current market value.
So when I inherit this investment property, I could sell it for its current value and no capital gains would be recognized!
1031 Exchange Infographic Courtesy 1031Gateway
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