Most often when we think of the word exchange, we think of returning an item to the store for a different size or we think of changing our currency for the currency of another country to which we are traveling. Usually it's only the experienced real estate investor who thinks of an exchange as applied to real estate.
A real estate exchange or 1031 exchange was created to help investors defer paying capital gains taxes on their investment properties until a future date. Capital gains taxes are charged on investment properties at the time of sale unless an exchange is arranged. The rules are quite stringent for completing an exchange so it's wise to consult a real estate agent who is experienced in exchanges.
A summary of the rules follows:
- The property being exchanged must be an investment property.
- The property being exchanged (the property being sold) must be exchanged for a like kind property of equal or greater value.
- Like kind property means investment property exchanges for investment property. For example, a residential rental property may be exchanged for a warehouse rental property.
- The money from the sale of the first property must be held by a qualified intermediary. The seller cannot touch any of the money from the sale.
- The seller of the exchange property has 45 days from the closing of the relinquished property in which to identify 3 properties or 3 groups of properties which will be purchased to complete the exchange.
- The seller of the exchange property has 180 days from the closing of the relinquished property in which to close on one of the three properties or groups of properties identified as the exchange properties.
- Monies from the relinquished sale will be applied to the purchase of the exchange property.
If the criteria above is not met, the seller will have to pay the capital gains tax on the property s/he sold. More information can be obtained here.
My husband and I own 80 acres which we have used as a weekend retreat and hunting land. We have owned the property for many years, but never rented it. We recently considered placing the property on the market. One of the issues we considered in our decision making was the fact that we will have to pay capital gains tax on the "profit" from this land. We realized that if we wanted to avoid that tax problem, we would have to turn the property into a rental for a minimum of 2 years and then "exchange" it by selling it and buying a new "rental" property. Once we purchased the rental with the cash from the acreage, we could mortgage the new property and use the funds from that mortgage for home improvement or for any fun thing we'd like. Prior to the purchase with the exchange funds, we could not touch that money. We haven't yet decided if we want to "rent" our acreage or not. It may just become an inheritance for our children, and they can worry about the taxes!
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