Anyone who has recently sold property in Hawaii – or is thinking about taking that big step – should know about the 1031 Exchange.
The 1031 Exchange is a financial process that has helped many new home sellers by saving them a significant amount of money when they need it the most.
1031 Exchange: What it is and Why it’s in Place
The purpose of a 1031 exchange is to alleviate some of the burden of paying capital gains tax for a person who has sold their property. Acquiring or selling property is always a costly process, and most people who go through it are looking for a way to make their finances more manageable after the sale has been finalized.
That’s why the 1031 Exchange allows these capital gains taxes from the sale of investment properties to be deferred as long as those proceeds from that sale are used to buy a new property. This replacement piece of property has to fall under certain conditions, such as being similar enough to the sold property to be considered a replacement.
One of the key advantages of this exchange is obviously the amount of money you save on taxes in the process. If you’re already going to be in the market for a replacement property once the deal on your existing property has gone through, it makes all the difference to have as much capital available for it.
This is also perfect for those who have sold an investment property and didn’t do as well as they’d hoped. By using their modest returns on the investment to help pay for a new similar property, you’re giving yourself a second chance to make a significant profit.
1031 Exchange Timeline
The first step in going through this process is meeting certain qualifications. These exchanges are intended for real property to real property – the exchange of personal property is not permitted.
The applicant has to prove that both the property they’re selling and the one they’re purchasing are being held for what’s known as “productive use” in either an investment, trade, or business. The rules of this exchange prohibit flipping this new property for a profit, for instance.
Not all exchanges result in a 100% deferral of taxes. The only way for taxes to be fully deferred is if the replacement property cost at least as much as what your previous property was sold for. This cost takes all customary closing costs into consideration. It’s also important to remember that reinvestment of both gain and basis is necessary for these calculations.
Within the 1031 Exchange, there are four distinct processes, each with their own timeline. These are:
- Delayed Exchange – With the Delayed Exchange, you have 180 days after selling one property to acquire the replacement.
- Reverse Exchange – A Reverse Exchange occurs when an individual purchases their new property before the relinquished property has actually been sold.
- Simultaneous Exchange – Simultaneous Exchange, as the name suggests, is when both properties close at the same time.
- Improvement Exchange – For the Improvement Exchange, you are allowed to put exchange funds towards improving the replacement property while the title sits with an exchange accommodation titleholder, or EAT.
Qualified Professionals Are There to Help!
With the complex and time-sensitive rules behind a 1031 Exchange, it’s not just a good idea to have certain professionals involved – sometimes it’s a requirement.
A tax advisor will help you establish property values. A qualified intermediary, who the Treasury Regulations requires, is there to prepare documents, consult with advisors, and fill a variety of other official roles. Real estate professionals are highly advisable to consult with as well: They know this business better than anyone.