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1031 Exchanges: Are They Right For You?

Are you in the process of selling an investment property and looking to avoid paying taxes on your gain? You may have been encouraged by your CPA or real estate agent to pursue a 1031 exchange. The capital gains tax could be as high as 15% - 30% when state and federal taxes are combined, so using a 1031 exchange as a tax and investment strategy could be a wise move.

What is a 1031 Exchange?

A 1031 Exchange allows investors to defer capital gains on the sale of a property while trading up to a higher quality asset. Simultaneous, reversed, and deferred are the three types of exchanges available to investors. The most commonly used exchange is a deferred exchange, which accounts for up to 90% of all 1031 exchange transactions.

A deferred exchange works like this: when an investor sells a property, they have 45 days from the close of escrow, also referred to as "down leg", to identify new properties, referred to as "up leg". The investor then has an additional 135 days to close escrow on the replacement property or properties. This provides a total of 180 days to complete the exchange. The investor must notify and contract with a qualified intermediary (neutral third party) to hold the funds from the original sale for their benefit until a new property has been identified and acquired.

Additional Guidelines to Consider

In addition to the time restrictions mentioned above, the exchange investor has other rules to adhere to in order to defer 100% of the capital gains tax on the property relinquished or sold:

1. The replacement property must be "like-kind" to the relinquished property. This is any property held as an investment or used in a trade or business

2. The "up leg" property must be of equal or greater value to the sold property

3. The exchange investor must have the same or greater debt on the replacement property as was held on the sold property

4. All the equity must be reinvested into the replacement property

5. The exchanger must take title to the up-leg property the same way that they held title to the down-leg property

6. Individuals, LLC's, Partnerships, Trusts, and Corporations can all execute a 1031 exchange

A 1031 exchange is a very valuable tool and allows investors to build wealth over time by deferring capital gains. In Part 2 of my 1031 Exchange series, I will explore selection guidelines and identification rules to help guide you to your best investment.

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