In a nutshell, a 1031 Exchange is a swap of one asset for another. Most swaps of assets are taxable but a 1031 Exchange can be tax free.
Generally speaking, when you sell an asset, you have to pay taxes on the gains. If you sell an investment property, pocket the profit and dump it in your savings account, you will have to pay taxes on any gains. This is obviously a mistake if you intend on buying another property shortly thereafter.
In a 1031 Exchange, you can avoid paying taxes on the gains if you swap the real estate property you just sold for another like-kind one within the designated timeframe specified by the IRS as long as you never have direct access to the cash gained from the sale. The IRS specifies that you must designate a replacement property within 45 days and close within 6 months. You should not receive any cash at all, otherwise, it is taxed.
To perform a 1031 Exchange properly, you need to insert a special clause in the purchase and sale agreement specifying that you are relinquishing the property and will be exchanging it for another one. The funds received from the sale of the property should not go to you but rather to a qualified intermediary of your choosing such as a bank or law firm. The intermediary will handle the funds throughout the 1031 Exchange transaction. You should never have direct control over the funds. You should identify one or several replacement properties and communicate that in writing to the intermediary within 45 days and then close on the property within 6 months of the sale of the relinquished property or the due date of that year’s income-tax return, whichever comes first. Finally, you need to file IRS form 8824 with the IRS to effectively defer the taxes.
There is no limit to the number of times you can do a 1031 Exchange. You can keep repeating the process as long as you want from one property to another while avoiding paying capital gains.
As always, it is highly recommended to seek professional help from an attorney, tax specialist or accountant since 1031 Exchanges can be very tricky given the strict IRS requirements at a federal level and potential additional state level requirements.
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