Sometimes, investment property holders may want to make a change. However, concerns over the potential tax implications keep some from taking such leaps. Through the 1031 tax-deferred exchange, they have the ability to replace investment properties with others, while avoiding a heavy tax bill.
Investors looking for a change may find it helpful to have an understanding of how 1031 exchanges work.
The federal tax code provides that owners have the right to trade real property held for income purposes with other property of like kind with the same intended holding use. According to Kiplinger.com, in swapping out one property for another, investors will use one of three identification rules based on their specific circumstances. These include the following:
- The three-property rule lets investors identify three potential replacement options without restriction on their market values
- The 200% rule allows investors to pick out numerous potential purchase or exchange properties if their cumulative value does not exceed 200% of the original property’s value
- The 95% rule lets investors choose any number of potential replacement properties provided their values equal 95% of the original property’s total value or more
Investors have 45 days from the original property’s sale date to identify replacement properties, and they must close the transactions within 180 days.
Defining like-kind properties
According to the Internal Revenue Service, relinquished properties and replacement properties in 1031 tax-deferred exchange cases must meet certain criteria. To this end, the IRS defines like-kind properties as those of the same character, class or nature. The quality of the property does not weigh into this decision.
Careful planning before making any property transactions helps many investors identify options such as the 1031 exchange, which may aid them in deferring tax liabilities for capital gains.