1031 Exchange Explained for Investors

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Even though 1031 exchange has existed for a very long time, many investors are not aware of this clever money-saving technique.

That’s precisely why we wanted to explain it so you can save money in future reinvestments and become a top real estate investor.

What Is a 1031 Exchange

The best way to understand 1031 exchange is to tell you what it’s used for – it allows you to avoid paying capital gains taxes whenever you sell a property and then reinvest the money in another one or several.

Naturally, you need to do this in a certain time limit and by reinvesting in properties of a like kind which are equal or of higher value.

This type of exchange is within Section 1031 of the US Internal Revenue Code, and it requires an independent, third-party qualified intermediary. This person will act as an intermediary by keeping the gains from the sale before transferring them to the seller of the second property that’s being purchased.

The Role of Depreciation in 1031 Exchange

First, let’s start by telling you that depreciation is an essential concept in grasping the benefits of the 1031 exchange.

It’s essentially the percentage of the investment property cost that’s omitted every year. These exist to recognize the existence of wear and tear effects on property.

Now, all of this means that you get to lower your capital gain taxes which are based on the property’s net-adjusted worth, which reflects:

  • The original purchase price of the property together with

  • Capital improvements minus depreciation

What is Like-Kind Property?

If you’re going to reap the benefits of 1031 exchange, you need to reinvest in a like-kind property as we already mentioned in the beginning. But what constitutes a like-kind property?

As a like-kind property defines according to its nature and characteristics, there is a wide range of real estate properties that can be exchanged.

However, there are still specific rules you must follow. The replacement property:

  • Must be kept for investment and not for resale or personal use, meaning it was most likely owned for two years or more.

  • Should have an equal or higher value than the property you’re selling.

  • Must be found within 45 days and the whole purchase must conclude within 180 days.

Additional Things You Should Know

  • Both properties can have mortgages, but if the replacement property’s mortgage is a lesser amount, then the difference will be treated as a cash boot.

  • If an LLC wants to exchange property, all partners must agree to the terms. If one or more doesn’t, then they need to treat the property as an entity, unless they decide to do a drop and swap.

  • Tenancy in common allows everyone to have fractional ownership of a larger property, along with one to 34 more people or entities. Investors using this method can have ownership of a property with other owners yet still keep the rights a single owner has.

The Bottom Line

A 1031 exchange provides an excellent opportunity for investors looking to gain a significant tax reduction. Even though the whole ordeal can get complicated, it’s more than worth it. For more information, you may reach us at info@LLCPM.com and get additional help with 1031 exchange.