While 1031 exchanges can seem complicated and daunting, using a 1031 exchange can help you avoid paying large amounts of capital gain taxes when selling an investment property to buy another investment property. The Internal Revenue Service allows property owners to defer their capital gains tax if they replace the property with a “like-kind” property.
Rules for Prospective Replacement Properties
In a 1031 exchange, you must follow strict rules, or you can be barred from deferring your capital gains tax. When evaluating prospective replacement, there are three numbers to remember: 3, 200 percent, and 95 percent. Review these rules to determine which one will provide the best strategy for your situation.
- 3: Under the rules of a 1031 exchange, you can only identify three replacement properties. If you identify three replacement properties and then buy something not on that list, you will not be eligible to defer your capital gains tax.
- 200 percent: You can acquire multiple properties if their combined value does not exceed 200 percent of the relinquished property's sale price.
- 95 percent: If you are acquiring multiple properties, you can identify more than three. However, you must acquire at least 95 percent of the identified property's value. For example, if you identify 15 properties and the total value of those properties is $100 million, you must acquire at least $95 million worth of those identified properties. If you identify more than three properties and fail to acquire 95 percent of the identified property's value, the 1031 exchange will be nullified, and you will be required to pay the capital gains tax.
Strategize Before Relinquishing Your Property
In a 1031 exchange, you are on a strict timeline that begins once you relinquish your property. For example, once you relinquish your property, you only have 45 days to identify your replacement property and 180 days to close on your replacement property or properties if you are buying multiple. The 180-day closing window will be shorter if you close late in a year because the exchange must be finalized before the Federal tax return filing deadline. As a result, you should have a solid strategy before relinquishing the property and those timelines, or you risk losing your chance to participate in a 1031 exchange.
Solidify Your Exchange Team
All 1031 exchanges require a qualified intermediary who acts as a third-party fiduciary. The qualified intermediary will ensure that all the rules and deadlines are followed to keep the exchange compliant.
Look at the Whole Market
While there are strict rules you must follow when performing a 1031 exchange, they are relatively loose regarding what type of property may be used as a replacement. You can identify and buy a property with a different use from the one you are selling.
As a result, it may be worth looking at the whole market and not limiting yourself to one type of property. You can do this by contacting a real estate agent or broker who will understand what properties are available in your area and help you find something that fits your wants and needs.
Launch Immediate Due Diligence
You have a tight window to identify and close replacement properties. Usually, due diligence on commercial properties takes quite a while, so you should begin due diligence on the properties you are considering immediately to avoid issues that require pulling out of the sale after the identification window has expired.
Ensure Replacement Property Financing
To defer your capital gains, you must obtain a property of greater or equal value to the one you sold. All the money made from the sale must be reinvested in the replacement property. As a result, if you buy a property worth more than the property you sold, you will need financing. You do not want to run into issues once the identification window has expired. You are closing in on the 180-day closing deadline. If you fail to close on time because of financing issues, you will not be able to defer your capital gains tax.
Contact an Experienced Real Estate Attorney
Having a qualified team to help you with your 1031 exchange can make a difference in the smooth process of your sale and purchase of properties. Contact Brazos 1031 Exchange Company to discuss strategies for completing a successful 1031 exchange. Simply call us at(888) 508-1901 to schedule a consultation.
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