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Posted on October 28, 2016 By

How a 1031 Exchange Works with Rental Properties

Rental properties provide several great benefits, including tax benefits from the IRS. You can depreciate rental properties in order to save on taxes, and with a 1031 exchange, you can sell rental properties and defer the taxes on any gains made or recaptured depreciation.

But what is a 1031 exchange and how does it operate? A 1031 exchange is a real estate transaction involving two similar properties – one that is sold and one that is bought within a particular period of time. There are a lot of limitations on a 1031 exchange, and the IRS is not very clear in describing these. Some fundamental principles are that the properties must be used for business; in the possession of the owner for at least a year; and the replacement property should be identified in 45 days and purchased in 180 days. If these requirements have been met, a rental property can be sold not incurring any taxes on the profit or recaptured depreciation.

Taxes Owed without a 1031 Exchange

Selling a rental property means you pay taxes on any gains you make on the property. You may as well need to pay recaptured depreciation. The IRS allows rental property depreciation since they believe a building has a short life span and lowers its value year after year. You can take that depreciated amount from your taxes annually, and that is a substantial bonus for anyone owning a rental property. But if you decide to sell the rental property for a price that exceeds the depreciated value, you will have to pay back any taxes you saved.

Properties Suitable for a 1031 Exchange

A 1031 exchange can be used on many different types of real estate properties. Any property, including rental properties, used for business could also work with a 1031 exchange. Even mineral or water rights can even qualify.

The following though cannot be used:

> Stock in trade or all properties that are held firstly for sale

> Stocks, notes or bonds

> Other securities or any evidence of interest/indebtedness

> Partnership interests

> Beneficial interest or trust certificates

> Choses in action (a right to something, like payment of debt)

Reverse 1031 Exchange

It’s typical for investors to sell a property and buy a replacement property. It’s also possible to pay for the replacement property before you sell your original property. However, this may be difficult since the investor will not have the cash from the first property’s sale.

It may work though for an investor constructing a replacement property that can be exchanged into. The time needed to build and buy a property might take longer than 180 days; and that is why reason an investor might consider a reverse exchange.


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