Paying taxes on real estate investments is usually inevitable. However, a 1031 exchange is a valuable tool often used by real estate investors to defer payment of capital gains tax and keep more money in their pockets. When it comes to employing a 1031 exchange in a real estate transaction there are certain rules that must be followed, so it is important to consult experienced Pennsylvania real estate lawyers before taking the plunge.
Understanding a 1031 Exchange
Section 1031 of the U.S. Internal Revenue Code enables property owners to avoid paying capital gains taxes on certain real estate transactions. You can only use a 1031 exchange when the proceeds from the sale of an investment property are used within a certain time limit to purchase another property or properties of a similar type and equal or greater value (like-kind).
What is a Qualified Intermediary?
When you sell a property and want to use a 1031 exchange to avoid paying capital gains tax, the proceeds of the sale must be transferred to a qualified intermediary. A qualified intermediary is an individual or company that facilitates the 1031 exchange by holding funds in escrow until they are transferred to the seller of the replacement property.
The 1031 Exchange Process
The property that is being sold is known as the upleg, and the property or properties that it is exchanged for is called a downleg. Once proceeds from the upleg are transferred to the qualified intermediary, you have 45 days to identify or choose the new property you want to purchase.
Once you’ve informed the qualified intermediary of the downleg you intend to purchase, you have an additional 135 days to close escrow and take possession of the property. This gives you a total of 180 days from the beginning of the process to the end. These are strict deadlines and at no time can the funds from the upleg sale be in your name, or you will owe capital gains tax. If you plan on doing a 1031 exchange as an LLC or another type of business entity, it is important to seek the advice of business liability lawyers who are well-versed in these types of real estate transactions.
Benefits of a 1031 Exchange
In addition to deferring capital gains taxes, a 1031 exchange enables investors to more easily move investments and diversify their portfolios to minimize risk. It is also useful for owners who want to switch from investment properties such as apartment buildings that require a lot of hands-on management to properties that require less direct involvement.
A 1031 exchange can also be employed for estate planning purposes. If you purchase a property through a 1031 exchange and then pass away, your heirs will likely receive it at a higher market value and will not have to pay the deferred capital gains tax amount. If you are considering this strategy, it is vital to consult lawyers for real estate and knowledgeable estate planning attorneys to ensure it is done correctly.
This is just a brief synopsis of what is involved in a 1031 exchange. There are different types of 1031 transactions, and there are many specific rules and procedures that must be followed. Our legal team includes some of the best contract lawyers, real estate attorneys, and living will attorneys in Pennsylvania. We can determine which type of 1031 best meets your needs and goals and guide you through the process from start to finish.