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1031 Exchanges Explained

What exactly is a 1031 Exchange, also called a “Like Kind Exchange” or a “Starker Exchange.” Whatever the name, a 1031 Exchange allows investors to defer paying capital gains taxes on investment property when it’s sold, as long as another “like-kind” property is purchased with the profit netted from the sale of the first property.

The 1031 Exchange is often used by financially successful investors and many of them feel this year is the prime time to exchange properties in expensive markets for cash flow properties across the United States.

So what’s the best time of the year to do a 1031 Exchange? Basically, if you own a rental property that is worth a lot more today than you purchased it for, you can make a substantial amount of money by doing a 1031 Exchange.

In order to do a 1031 Exchange and get the most out of it, you will have to exchange one property for another property of similar value, which helps you avoid capital gains (for the moment).

Investors will at some point cash out and pay taxes but for the moment, they can trade properties without incurring a tax fees. Keep in mind that the 1031 Exchange rules require that the purchase price and the new loan amount be the same or higher on the replacement property. What that means is that if an investor wanted to sell a $2 million property that had a $1 million loan, they would have to buy a replacement property for at least $2 million with $1 million or more leverage.

It’s important to note that there are four different types of 1031 Exchanges:

 

  • Simultaneous Exchange – Allows investors to relinquish and close on a replacement property the same day.
  • Delayed Exchange – The most common type of 1031 Exchange, this one lets the investor sell their investment property first and then find a replacement property within a certain time frame.
  • Reverse Exchange – This one sounds like it’s the easiest because you make the purchase and pay later. The reason it’s not the most popular is that this exchange has to be an all cash purchase and most banks won’t lend to you. Why? Because you can’t be on the title to the replacement property and the relinquished property at the same time. You can, however, create an LLC that can take title to the replacement property and once it’s sold you can transfer the title of the replacement property into your name.
  • Construction/Improvement Exchange – If an investor sells a property and then realizes that the one they want to purchase costs less than the one that was relinquished this is the route to take. This exchange lets you use whatever funds are left to build or improve on the property you want to purchase.

 

Remember, to qualify for a 1031 Exchange, the property you sell and the property you want to purchase must be the same nature or character, even if they differ in grade or quality. For example, exchanging a duplex for an apartment or a single dwelling home for an office building would be allowed while trying to exchange construction equipment for a home wouldn’t be.

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