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A-B-C of 1031 Exchange

By Sadiya Anjum

1031 Exchange also referred to as like-kind exchange/ tax deferred exchange/ starker exchange is defined in Section 1031 of the Internal Revenue Code (IRC). It gives the liberty to an individual to invest all his proceeds from the sale of an asset into another without having to pay the capital gains tax.

1031 Exchange states that the proceeds obtained from the sale of an asset (usually real estate) when immediately invested in another similar asset, no gain or loss is counted and the capital gains tax is deferred. The tax does not disappear; one has to pay it when the individual ultimately sells his investment for cash. Until then he may employ 1031 Exchange in as many transactions as he may want. It allows the freedom to sell one property and invest the proceeds in more than one property, or sell several to invest in one.

1031 Exchange is applicable only for properties that are productively used for trade, business, or investment purposes. It cannot be applied to residential properties. 1031 Exchange can be highly beneficial for investors. It allows you to invest your net equity in another asset of higher value, thereby providing easy scope to invest in larger projects. 

1031 Exchange may not necessarily allow you a 100% tax deferral. For this, you must invest your entire proceeds in your replacement property. Any extra cash retained from the transaction will be accounted as taxable income. This amount is referred to as the boot.

Tax-deferred Exchange allows a safe way to expand your investments but there are several rules that you need to follow. Both properties (relinquished and replaced) have to be of a like-kind. This does not relate to the physical attributes of the property but other similar factors. For instance, a real property sold should be replaced with a real property. The replaced property should be equal to or greater in value than the relinquished property. The mortgage on the new property should also be equal to or greater than the existing debt on the old property.

The taxpayer for both the properties has to be the same individual. 1031 Exchange has to be conducted with the aid of a Qualified Intermediary/ Accommodator/ Facilitator. The Qualified Intermediary is a neutral third party who facilitates this exchange. The entire procedure is done under his watchful eye and the proceeds from the sale are held by him until you find your replacement property. If at any point during this period, you take control of the proceeds, it invalidates the 1031 Exchange.

Most of the guidelines are not too stringent to follow but there is one that can prove difficult but far from impossible. Section 1031 specifies that the replacement property has to be identified within 45 days after the closing on your relinquished property. You are allowed to identify three properties and there are several other details associated with finding replacement properties. Generally, within 180 days after the closing on the relinquished property, the closing for the replacement property should take place.

You should find out further details so you can utilize the tax-deferred exchange effectively. Stick to their guidelines as so many others have been doing, and it may help you expand your reach as an investor.

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