1031 Exchange Is Typically Used By Sharp Investors To Acquire Benefits By Deferring Capital Gains. The Meaning, Types, And Adjustments In 2021, You Can Learn More From The Article.

1031 Exchange Rules 2021 is a real estate term that refers to the swap in investment property in order to defer taxes of capital gains. The name is obtained from Section 1031 of the IRS code, which describes investors, realtors, and title companies.

There are plenty of dynamic parts within Section 1031 that essential to be understood before you attempt to use it. Exchange can be done only for “like-kind” properties and the uses are limited for vacation properties by IRS. There also exist implications of taxes and time frames that could be turned against the users. Therefore, if you still want to learn about the rules, proceed to read the following passage.

1031 Exchange Rules 2021

What Are 1031 Exchange Rules?

As mentioned in prior, 1031 exchange is an act of swapping investment properties. It is also commonly referred to as Starker or like-kind exchange. The majority of swaps are applicable for taxes as sales, but you may defer tax or granted with limited tax if you can meet the 1031 exchange’s requirements.

As the result, according to IRS, you will be able to alter the investment forms without the investment being recognized as capital gain or being cashed out. This lets the investment keep on being deferred from tax. 1031 is basically can be done for infinite amounts of times. You’d be capable to overthrow your real estate investment’s gain from one to another, and then to another, and then to another. You may not gain profit from every single swap, but you will avoid tax until the investment is sold, even if it takes years later. If everything works out as the system is planned out to be, then you only need to pay a single tax at a 15% or 20% rate of capital gains in long term, depends on your income. It can even be 0% if you’re categorized as taxpayers with a lower income class.

The 1031 Exchange Rules 2021 is used for the property of business and investment only. However, it might be able to apply to the main residence property under some conditions. It is also actually possible to apply 1031 for vacation properties, but the opportunity is so low now compared to some times ago.

When to Use 1031 Exchange Rules?

There are several reasons why the 1031 exchange is worth to be considered by investors. Here are some of the reasons:

  1. There is a potential that you seek a property with better risk-return prospects or desire to expand your assets.
  2. You may seek a property that already managed rather than a property that you have to manage yourself as an investment real estate owner.
  3. You may wish to incorporate different properties into a single one, with the purpose of planning the estate, or as the opposite, you may want to divide one property into a few ones.
  4. You want to reset the depreciation clock.

The primary benefit of applying 1031 is essentially down to tax deferral, compared to selling and buying properties. It has been stated above that the exchange rules allow the applicants to defer taxation of capital gains, so they are able to free more investment capital related to a replacement property.

What Is Depreciation In the 1031 Exchange Context?

The core concept you need to understand in order to learn about the 1031 exchange benefit is depreciation. What is it, anyway? Depreciation is the amount of percentage of investment property’s cost that’s adjusted annually in order to recognize wear and tear effects.

There is a chance that you need to withdraw the depreciation if your investment property is sold more than its value of depreciation. It means that the depreciation amount will be incorporated within the taxable income of the property’s transaction of yours.

The recapture depreciation’s size rises as time goes by. So, you may want to consider the 1031 exchange in order to prevent a drastic increase that’s caused by depreciation recapture to your taxable income. It is definitely a factor that’s worth taking into your account when trying to calculate the 1031 exchange transaction value.

What Are Types of 1031 Exchange Rules?

1031 exchange provides a broad range of options for investors of real estate to grow, scale-up, or diversify their investment portfolios. There are several types of like-kind exchanges – each has a bit different requirements and procedures set that must be obliged so it won’t trigger tax of capital gains accidentally. Here are the types:

  • Simultaneous

Simultaneous exchange happens is the like-kind exchange occurs within the same day. This is the original 1031 exchange form until the law of taxes is updated to allow the possibility for other types.

  • Delayed

Delayed exchange occurs if you sell the property, receive cash, and purchase another property by delay. The delay may happen for a single day to a few months before you finally acquire the replacement property. If the replacement property is not purchased within the IRS’ determined time frame, then you need to pay your property sale’s capital gain.

  • Improvement

Also known as construction exchange, improvement exchange occurs when you want to use tax-deferred money to improve the replacement property. However, the money is kept by the middle man.

  • Reverse

Reverse exchange happens if you buy the property first, and then exchange it later on. In this scenario, you need to purchase the replacement property first then organize the second property’s sale. This type of exchange is not really common to be used, because the deals need to be entirely in cash.

Delayed Exchanges and Timing Rules

A 1031 exchange has commonly happened as a property’s swap from one to another that involves two parties. However, the chance of finding another person that owns the exact property you have is tiny that’s why most of the exchanges are included in delayed, starker, or three-party categories.

For delayed exchanged, you have to involve a middle man or intermediary who will hold keep the cash after the property is “sold” out, and then uses the cash to “purchase” another property for you. The exchange with three involves parties like this is considered a swap.

There are two timing rules that essentials and have to be observed during the delayed exchanges:

  • 45-Day Rule

The rule is associated with the appointment of the replacement property. The middle man should receive the cash once the property transaction happens. You should not receive the cash as it’ll break the 1031 exchange.

Within the span of 45 days after the property is sold, the replacement property must be designated to the middle man, and the property that you wish to acquire should be specified. According to IRS, you may designate up to three properties, as long as you are nearby to one of the three. It’s even possible to designate beyond three properties if they meet with particular valuation tests.

  • 180-Day Rule

The timing rule associates with closing in the context of a delayed exchange. The new property must be closed in the span of 180 days after the old is sold.

1031 Exchange Rules 2021 vs. 2020

The 1031 Exchange Rules 2021 do not differ much from the 2020 version, as they both derived from the Tax Cuts and Jobs Act (TCJA) adjustment in 2017. Here are the upgrades that take place during the year:

  • Before the adjustment of the Tax Cuts and Jobs Act (TCJA), personal property exchanges are allowed – for example, aircraft, franchising and licensing, and equipment properties. Now, only real estate is allowed for the 1031 Exchange.
  • Tax Cuts and Jobs Act (TCJA) permits personal property that is no longer allowed for a year after adjustment happened.

IRC Section 1031 Fact Sheet PDF

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IRC Section 1031 Fact Sheet PDF [38.26 KB]

Frequently Asked Questions (FAQ) & Answers

What is a 1031 Exchange and How Does It Work?

It’s an exchange that allows the applicants to defer taxes of capital gains when they sell and reinvest property during certain time frames.

What Property Qualifies for a 1031 Exchange?

First is real estate property, such as commercial, residential, industrial, or rental properties. Second is improved real estate property, such as farmland or raw land and ranches like gas and oil royalties.

How Much Does a 1031 Exchange Cost?

1031 exchanges direct cost normally determined by the fee that charged over your QI. The fee of QI differs, but it mostly costs $600 to $1,200.

How Long Do You Have to Hold Property in a 1031 Exchange?

The properties can be held for five years before they are obliged for full tax again.

How Many Properties Can You Purchase in a 1031 Exchange?

IRS allows you to identify a maximum of three properties. However, with the 95% and 200% rules, there is a chance to involve more than three.

How Much Do You Have to Reinvest in the 1031 Exchange?

Typically, the like-kind exchange is utilized to avoid taxation of capital gain, by doing 100% reinvestment from the sale of a property into the replacement property.

Note: please keep in mind that 1031 Exchange Rules 2021 may require you to obtain holding time and minimum investment that relatively high. This is what causes the transaction to be more common for people that have a higher net worth. The transaction also needs to be handled by experts because of their level of complexity.