After closing a profitable commercial real estate sale, your joy may suddenly come to a stop when you realize that you have a big bill the next time you file your returns. Luckily for you, you can use a strategy known as a 1031 exchange to defer the tax obligation indefinitely as long as you reinvest the sale proceeds into another replacement property of like kind.
A 1031 exchange is a tax deferral approach savvy real estate investors use to defer tax liability of a profitable sale of an investment property. 1031 exchange is derived from a section of the IRS tax code that recognizes no gain or loss on exchanging like-kind property for investment or business purposes. There are different types of 1031 exchanges designed to meet the needs of different investors.
A delayed exchange is very common in dst 1031 investments. It is when you sell the current property, also known as the relinquished property, and use the funds to buy another investment property known as replacement property. To facilitate the sale of the current property, you must use a qualified intermediary to hold the sales proceeds in escrow until you identify a replacement property. However, you must identify the replacement property within 45days and complete the purchase within 180days. This extended timeframe is what makes the delayed exchange desirable.
Like the name suggests, in a simultaneous exchange, the sale of the relinquished property and the purchase of the replacement property happen simultaneously or on the same day. There are several ways in which a simultaneous exchange can take place:
- Two-party trade whereby the two sellers swap deeds.
- A three-party trade where an accommodating party serves as an intermediary for the transaction.
- Qualified intermediary whereby an expert of 1031 exchange transactions manages the exchange of the funds between the two parties to ensure compliance with 1031 exchange rules.
A reverse exchange is the complete opposite of a delayed exchange. It happens when the replacement property is purchased before the sale of the relinquished property. Although the same timing rules as in delayed exchange apply, they are in reverse. Therefore the relinquished property or the investment property for sale must be identified within 45 days and sold within 180days.
This applies when an investor has multiple investment properties, so they have to decide which one they will relinquish in the 1031 exchange. It also has a higher risk because the investor doesn’t know whether the property will sell within the given period. Also, they must have the funds to buy the replacement property before selling the current property.
An improvement exchange applies when some repair needs to be done on the replacement property. So, the investor sells the relinquished properties, identifies a replacement property, and delegates it to a qualified intermediary. Then the investor uses the sales proceeds to facilitate repairs and repossess the replacement property upon completion. The property must be the same as it was before the improvement, and the repairs should be complete within 180days from the date of the relinquished property’s sale.
Your needs and the nature of the transaction determines the kind of exchange to use.