Mechanism Of The 1031 Exchange

One of the very difficult thing to achieve in Europe is managing to create a real estate fortune. Why is it easier in the States ?

One of the most important reason are taxes. Indeed, in Europe any profit made on property is subject to heavy taxes. So on top of extremely high transaction fees (notary, lawyers, real estate agents, transfer taxes and so on), you have to pay a large chunk of your capital gain as tax.

In the states a wonderful mechanism exists and it helped support the real estate industry. This procedure originates in the beloved Internal Revenue Code, specifically in the section 1031. A 1031 exchange or Like kind exchange is defined as follows:

If you own an asset, generally some kind of real estate such as land or building and you sell it with profit, you will be able to defer the payment of capital gains, under the conditions that you use the proceeds of the sale in order to reinvest in a like kind asset.

See the potential: you do not use precious cash to pay off taxes, you can re-invest immediately. However, you need to understand 2 things.

1 - It is a deferment, so should you sell without re-investing, the capital gain will be taxed and you will have to pay.

2 - In order to qualify certain conditions must be met:

a. the asset must be of like kind
b. the proceeds of the sale must be invested in a similar kind of asset within 180 days of the sale. (Furthermore, the property must be identified within 45 days)

This is an effective way to defer paying taxes.

A 1031 Exchange is similar to a traditional IRA or 401K retirement plan. In a tax-deferred retirement plans, when assets are sold, the capital gains that would otherwise be taxable are deferred until beginning of the cashing out of the retirement plan.

It is the same mechanism for tax-deferred exchanges or real estate investments. As long as the money is re-invested in other real estate, the capital gains taxes can be differed.

How do you make a 1031 Exchange ?

Once you have decided to pursue a 1031 Exchange, the process is rather easy. If you use a professional, it should as well be carefully facilitated. So do not hesitate to ask around. Once you have your advisor here is what will happen:

you put your investment property on the market. Then you make a new offer to purchase the investment property. The offer is accepted. Escrow for the sale is opened and preliminary title report is produced. Your advisor provides the necessary exchange documents to escrow closer for signing at property closing. Then Escrow closes. Now, within the first 45 days after the close of escrow on the sale of the relinquished property, you identify the replacement property as required by Law. Last, within 180 after the close of escrow on the sale of the relinquished property you close on the replacement property.

Often, the most difficult part of a 1031 Exchange is identifying replacement property within the first 45 days following the sale of the relinquished property. Be careful, the IRS does not grant extensions.