If you are interested in investing in real estate you should learn about the Internal Revenue Code Section 1031. It is considered as a very powerful tax deferral tool that is presently available for taxpayers.
This section allows a tax-deferred exchange. It means that the taxpayers need not to pay income tax on selling their investment property provided they reinvest the proceeds from sale in any similar kind of property.
There are many advantages of the 1031 tax exchange and it encourages investors to continue investing in real estate. The first and most important advantage that this section offers is that the taxpayers need not to pay federal income tax on the sale of their investment property, provided they reinvest the proceeds in a similar kind of property.
An important part of this section is that you can be benefited from it only if you reinvest the proceeds of sale in purchasing same kind of property. As per the IRS similar kind of properties means properties that are same in nature or character. However the quality and grade of the property may be different. The properties that are qualified under this section include retail and commercial properties, rental houses, offices and industrial buildings, apartment buildings, undeveloped land and ranches.
The properties that do not find their place in section 1031 are business inventory, personal residences, interests in business and properties that are owned by dealers.
There are several advantages of section 1031 for real estate investors but it has one main disadvantage. The basis of depreciation on replacement property is reduced by this section. It means that the replacement property will include a sort of deferred gain and this gain will be taxed at the time of selling of that property by the investor.
Section 1031 supports four types of exchanges. The first exchange supported by it is a simultaneous exchange. This sort of exchange happens when both the properties are closed on the same day by the taxpayer. It is generally a back-to-back transaction and closings do not have any lapse of time.
The second type of exchange is a delayed exchange. It is also called a Starker exchange. It means closing of the replacement property after the closing of relinquished property. A delayed exchange does not take place on the same day. It is strictly regulated by the time frames as mentioned in the section 1031. The taxpayers are allowed a specific time to search for a suitable replacement property and sign the contract to purchase that property.
The third exchange is called a title-holding exchange. This exchange takes place when the replacement property is closed before the closing of the relinquished property. In this transaction, the intermediary holds the rights on the replacement property until the taxpayer has closed the deal of the relinquished property.
The last exchange is an improvement exchange. This exchange serves the title holding exchange as well. It is a situation when the taxpayer purchases a property and arranges for its improvement before it is termed as replacement property.
Section 1031 does not allow taxpayers to improve a property, therefore a mediator is employed to hold and close the title of the property until it is ready to be termed as replacement property. When the property is ready the mediator will then pass the title of the property over to the taxpayer.
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