- 1031 exchanges can be very beneficial for investors to defer capital gains taxes.
- There are, however, specific rules you have to follow to qualify for 1031 treatment.
- If you want to sell a foreign property in a 1031 exchange, you likely have to purchase a property in that same country.
I hope everyone had a great Fourth of July. Its my favorite holiday. Part of that is growing up in Michigan, I longed for any occasion where it would be above 50 degrees outside. And – usually – in July we could expect it to be above that in Michigan.
But, more importantly, lets get to this week’s topic. I had a friend ask me a legal question about a specific 1031 exchange she is contemplating. It was a fun question and I didn’t know the answer right of the top of my head. I thought it would make a great blog discussion. So let’s talk about it.
How Can a 1031 Exchange Help a Property Owner
A 1031 exchange, also known as a like-kind exchange, is a powerful tax deferral strategy that allows real estate investors to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a similar property.
One of the primary benefits of a 1031 exchange is the ability to defer capital gains taxes. By reinvesting the proceeds from the sale of a property into a like-kind property, investors can defer paying taxes on the capital gains until they eventually sell the replacement property. This provides investors with an opportunity to preserve and reinvest more of their capital, allowing for potential growth and increased cash flow.
Additionally, a 1031 exchange offers the potential for portfolio diversification. Investors can exchange properties in different locations or property types, thereby spreading their risk and taking advantage of market opportunities. Furthermore, the ability to consolidate multiple properties into a single property, or vice versa, can provide operational and management efficiencies.
While a 1031 exchange offers numerous benefits, it is important to be aware of its drawbacks. One key drawback is the requirement to reinvest all the proceeds from the sale into the replacement property or properties. Failure to do so may result in the recognition of a portion of the taxable gain. Additionally, the exchange process can be complex and requires meticulous planning and coordination with qualified intermediaries and tax professionals, which can incur additional costs.
To qualify for a 1031 exchange, certain timing requirements must be met. The investor has 45 days from the sale of the relinquished property to identify potential replacement properties. The identification must be in writing and submitted to a qualified intermediary. Subsequently, the investor has a total of 180 days from the sale of the relinquished property to close on the purchase of the replacement property or properties. These timelines are strict and must be adhered to in order to qualify for tax deferral.
To qualify for a 1031 exchange, the investor must also directly own the properties bought and sold. This means that the investor cannot own an interest in an entity that owns a property. They have to own the properties directly. The properties involved in the exchange must be held for investment or used in a trade or business. Personal residences or properties primarily held for resale, such as fix-and-flip properties, do not qualify for a 1031 exchange. Additionally, both the relinquished and replacement properties must be of like-kind, meaning they are of the same nature or character, regardless of differences in quality or grade.
Can the Property You Sell be a Foreign Property
We see 1031 exchanges all the time and are familiar with how they work in a commercial transaction. But the next step from my friend was what made the exchange even more interesting. She asked if she could sell foreign property and still be able to defer capital gains under Section 1031. I’m not a tax expert so I didn’t know for sure. After doing some research, though, the answer emerged.
The bottom line is that to qualify for 1031 deferment, property must be exchanged for “like kind” property. And the IRS only considers the property to be like kind if it is in the same country as the property sold. In other words, if you are selling foreign real estate, you have to purchase foreign real estate to get the 1031 deferment. It does not appear that you can sell a property in a foreign country and buy a US property in a 1031 exchange.
Having said that, while Bukowski Law Firm is a great real estate firm – we are not tax lawyers. So if you want to know the specifics, I highly recommend you contact a tax lawyer or cpa. And if you don’t know one of those, give me a call. I can introduce you.