A Guide to 1031 Exchanges in Louisville
The selling of a property in Louisville attracts capital gains tax. Luckily, you may be able to forego payment of such taxes by using Section 1031 of the Internal Revenue Code.
The Code allows an investor to exchange their property for another like-kind one without incurring a capital gains tax. What’s even better, you can do that a countless number of times.
To be eligible, though, there are certain IRS requirements that you must follow. Here’s everything you need to know in that regard.
How Does a 1031 Exchange Work?
A 1031 property exchange is where “like-kind” properties are exchanged in accordance with Section 1031 of the U.S. tax code. It allows investors and businesses to sell a property without paying capital gains as long as the proceeds are used to buy a “like-kind” property.
The most basic type of exchange under the tax code involves swapping one property for another. The swapping, however, doesn’t take place simultaneously as it’s often than feasible. That’s why the IRS has time limits that an investors must adhere to for swaps to be successful.
There are various types of 1031 Exchanges. The most common is a deferred or delayed exchange. The exchange must be coordinated by a qualified intermediary. The intermediary acts as a link between the seller and buyer.
What Requirements Must be Met in a 1031 Exchange?
Properties must meet certain requirements in a 1031 Exchange. For one, they must both be used for investment or business or trade and be “like-kind.” Generally speaking, this means that the properties being exchanged must be similar in regards to class, character, and nature.
That said, the properties may differ in terms of quality. The following are sets of exchanges that can qualify under a 1031 Exchange:
- A single-family rental for a condominium rental.
- Retail property for a hotel.
- A shopping center for an apartment building.
- An industrial building for raw land.
- A warehouse for an office building.
How Can One Make an Exchange?
Let’s suppose you own a commercial building and want to make a delayed exchange. The first step to take would be to pick a qualified intermediary. An intermediary must not be your associate for example, someone who has acted or is acting as your broker, investment banker, accountant, attorney, employee, or real estate agent within the last 2 years.
The following are the roles of a qualified intermediary in a 1031 Exchange:
- Acquire the original property from you
- Facilitate the transfer of the property to the buyer
- Open an escrow account and hold the net sale proceeds
- Acquire the replacement property you intend to purchase from the seller
- Ensure the replacement property is transferred to the borrower
- Ensure all paperwork and steps in the exchange are done within the timeframe
In a delayed exchange, there are two timelines that you must follow. One is the 45-day time limit. Here, you must provide your intermediary with the description of the replacement property after the sale of the relinquished property.
Next, you’ll have 180 days to close on the replacement property. This actually means that you’ll have 135 days to close on the replacement property once you’ve sold the relinquished property as the 45-day limits are included in this.
It should be noted that the two-time limits refer to calendar days. Not business days.
What Happens in a Simultaneous Exchange?
In a delayed exchange, you have to sell your property first (relinquished property), find another one (the replacement property), then close on the replacement property by a certain date.
In a simultaneous exchange, you sell one property and buy another at the same time. There are no timeframes to adhere to. For example, consider two investment property owners who both want to complete an exchange. It’s entirely possible for them to just swap their deeds and complete a 1031 exchange.
A third party can also facilitate a simultaneous exchange between a property buyer and seller.
What Happens in a Reverse 1031 Exchange?
This is simply the opposite of a delayed exchange. The Code recognizes that it’s entirely possible for an investor to identify the property they want to buy before selling the one they have.
You’ll have a maximum of 45 days once you buy the new property to identify the property you wish to sell. You’ll then have another 135 days once you’ve bought the new property to finalize the exchange.
How Does an Investor Avoid Boot in a 1031 Exchange?
Boot is a portion of sales income received from a 1031 Exchange that an investor doesn’t reinvest in a replacement property. Suppose you sell a property for $300,000. But rather than re-investing 100% of the funds in a replacement property, you only invest $240,000. The difference of $60,000 is what would now become the boot and is taxable.
Aside from a cash boot, boot can also take place in any of the following ways:
- Exchanging properties that aren’t “like-kind.”
- Relief from debt on the relinquished property.
- Proceeds from an exchange in the form of a note or sale contract.
- Non-qualified property, like notes, bonds, or stocks.
To avoid boot, here’s what you can do. One, buy a property that is deemed “like-kind” and with an equal or greater value than the property you’re relinquishing. Two, reinvest all the net equity from the sale of relinquished property in the buying of a replacement property. And three, ensure the replacement property’s debt is equal to or greater than the debt of the property you’re relinquishing.
Whether you’re a first-time investor or have a large portfolio, making use of a 1031 Exchange can help you quickly grow your investment portfolio in Louisville. However, for the exchange to proceed, it must strictly follow all the requirements under Section 1031 of the U.S. Property Code.