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What is a 1031 Exchange

A 1031 Exchange is a powerful tool for real estate investors to defer tax when selling one investment property and buying another. Also known as a "like-kind exchange" or "Starker exchange," a 1031 allows an investor to defer tax payments on a property provided the proceeds from the sale are being applied to another investment. The loophole doesn't allow investors to get out of paying the tax indefinitely, as the tax will become due when the investor sells a property without using a 1031. An investor might use a 1031 to upgrade from one property to another several times, deferring tax on the profit made on each sale. When the investor sells his final property, without upgrading through a 1031, the profits for all the sales will become due at that time.

If a 1031 is used by an investor, and the replacement property is priced lower than the property exchanged for it, the difference will be considered taxable income. The loophole is named after the section in the IRS tax code that created it, way back in 1921. The intended purpose is to protect investors as they grow their portfolios. When one property is sold, and all the proceeds are re-invested, there is no actual gain, as the IRS sees it, because the proceeds went into buying another home. 1031's can be used for a variety of investments, so long as the investments are similar, hence the "like-kind" nickname. This means that a 1031 couldn't be used to sell a business and buy a rental property, but a business for a different type of business or a plot of land for a home is usually allowed. But regardless of the type of asset being exchanged, it's highly advisable to use an expert, as the code is lengthy and confusing and mistakes can prove very costly.

The 1031 loophole exists solely as a tool for investors, meaning it cannot be used to move up to a bigger primary residence. In addition, both the property being sold and the new asset must be held for a productive use in a business or investment. This means that house flippers cannot use a 1031, but those buying properties to rent out can, as can an investor simply buying an investment property in a down market to hold until the market improves. Only properties within the United States are qualifying assets for a 1031 exchange, and only properties used for business or investment, so personal residences do not qualify. Homeowners would be better served to use the primary residence tax break, which allows them to shield $250,000 in profit from the sale of a home provided they live there for at least two years.

There are five types of 1031 exchanges, each with slightly different qualifying criteria. The most commonly used type is called a delayed exchange, in which an investor sells the old property, then holds the proceeds for a period of time before acquiring the replacement property. Delayed exchanges are subject to strict time guidelines as laid out in Treasury regulations. Another type of 1031 is called a simultaneous exchange, meaning both transactions occur at the same time. The third type of 1031 is called an Improvement or Construction exchange, allowing the investor to use proceeds from his relinquished property to make improvements to the replacement property. A Reverse exchange, meanwhile, is where the replacement property is acquired before the replacement is sold. The final 1031 type is the Personal Property exchange, wherein personal assets are exchanged for similar assets. This type of 1031 does not apply to real estate, however, as personal residences are not eligible.

One key requirement for all 1031s is that the taxpayer must not receive the proceeds for a relinquished property. This means that he must find a third party to serve as a "Qualified Intermediary" in the process. The Intermediary holds the proceeds from the sale of the relinquished property, facilitates the purchase of the replacement, then delivers any leftover funds and transfers the title of the new asset to the taxpayer. A taxpayer cannot serve as his own intermediary in a 1031 exchange, and the intermediary is subject to the same qualification requirements as the taxpayer.

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