For many investors, a strategy that involves a 1031 exchange can be an excellent way to build a portfolio. A 1031 exchange allows you to defer payment of capital gains taxes on real estate gains, which lets you maximize the amount you put into your subsequent real estate investment. However, the process is very specific, and there are many limitations. Mistakes in the process could result in having to pay a significant amount in taxes sooner than you planned. It is extremely beneficial to work with a company to help you through the process. For those who wish to learn more, consider what the 1031 exchange process looks like.
How to Do a 1031 Exchange
The goal of a 1031 exchange is to defer capital gains taxes when you relinquish one real estate investment property to invest in another of equal or higher value. If you simply sold the property and took the cash, you would have to pay capital gains taxes in that tax year for any appreciation you realized. Here’s a look at the basic steps involved when you participate in a 1031 exchange:
Identify a Qualified Intermediary
The IRS has specific rules about how money is moved during a 1031 exchange. In short, you, as the investor, will not receive any cash in hand for relinquishing the original investment property. Instead, the cash is moved through a third party — a qualified intermediary, or QI, who works on your behalf. The QI handles the funds from the sale of the property. This party eventually will reinvest the money into a quality property that you elect to purchase. After you choose a QI to represent you, you can move forward.
How Does a 1031 Exchange Work From This Point?
Once you have a QI in place, you will list the property for sale. When it sells, the money temporarily goes to the intermediary. You have 45 days from the sale closing date to identify a property you wish to reinvest in. A failure to do so means you won’t qualify for a 1031 exchange.
Once you have selected a new investment property, you have 180 days to close on the purchase. The exchange will be completed as the funds held by the QI (and any additional investment amount) are turned over to the seller of your new property. It’s important to note that the purchase price and your new loan amount, if any, must be the same or higher than they were on the property you relinquished.
Why Use This Process?
The 1031 exchange process can be extremely beneficial financially, as it allows you to continue to exchange property and increase your net worth without having to pay capital gains taxes until it’s more advantageous to do so. There is no limit on the number of times you can be involved in a 1031 exchange. This process has been an important tool for title companies and real estate professionals in addition to casual investors.
At some point, you will want to cash out, and you will need to pay capital gains taxes in the tax year of your sale. However, maximizing your investment in the meantime will have allowed you to also maximize your additional gains.
It is critical to understand the 1031 exchange process and the rules. Your QI can help you with this process and works to streamline it every step of the way.