What Is a 1031 Real Estate Exchange?
A 1031 real estate exchange, also commonly called a "like-kind" real estate exchange, is a way to change properties without paying federal income tax when you sell the first piece of property. Basically, it is a smart way to defer income taxes on investment property, much like investing money in a tax-deferred retirement account like an IRA or 401k.
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Generally
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A 1031 exchange is a legal way to sell a piece of real estate and immediately purchase new piece of real estate without paying any income taxes right now. You will have to pay income tax eventually, but the 1031 exchange allows you to defer the tax payments until later, and this allows you to grow your money quicker.
Features
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To qualify for the special tax-deferment available under a 1031 exchange you must sell and purchase property of a "like-kind." In other words, the property you buy must be similar in nature to the property you just sold. For the most part, as long as you are dealing in real estate, it makes no difference what kind of real estate you buy, because all real property qualifies as like-kind. So you can sell farm property and use the money to buy apartment units, and you probably still qualify.
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Benefits
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The big benefit of a 1031 exchange is the deferment of income taxes. Assume you bought a piece of property 10 years ago. You paid $100,000 purchase price, but now thanks to appreciation and a hot real estate market, you sell the property for $300,000. Normally you would have to claim the $200,000 profit as income, and you would have to pay income tax on that $200,000. However, if you take the $300,000 from the sale of the property and purchase a new piece of property, you don't have to pay income tax yet. You can wait until you sell the next piece of property (unless, of course, you do another 1031 exchange).
Time Frame
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When you sell the first piece of property, you typically then have 180 days to purchase the next piece of property. But, if your tax return for the year comes due during that 180 days, and before you purchase the next property, then you may have to claim the income on your tax return. For example, if you sell Property 1 on November 30, 2009, you would typically have until May 30, 2010, to buy new property. But, your 2009 tax return is due on April 15, 2010, which means you have to buy the new property by April 15, not May 30, unless you get an extension to file your tax return later.
Warning
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While 1031 exchanges sound simple enough, they can become extremely complex in some situations. The money you will save from tax deferment easily justifies paying an attorney or other professional to help you with the 1031 exchange process. They will make sure you meet all the deadlines, file all the necessary paperwork, and don't do anything wrong. Doing a 1031 exchange on your own could result in a mistake which can cause you to lose the tax-deferment and also have to pay the IRS interest or late penalties.
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