3 Things You Need To Know About 1031 Exchange Transactions

Do you have a property that you want to sell? Are you facing a substantial capital gains liability on the property? You may want to sell the property under something known as a 1031 exchange. A 1031 exchange is a transaction allowed by the IRS that gives seller the ability to exchange one property for another without facing any capital gains tax. The catch is that the proceeds from the sale of the first property must go into the purchase of the second property. If you're planning on buying another property immediately, a 1031 exchange could be for you. Here are three things you need to know:

The property can't be for personal use. This is a major restriction in the 1031 code. The law exists to encourage real estate investment activity. As such, both properties involved must be investment or business properties. If the home you want to sell is a primary residence or a part-time vacation home, you'll need to move out for a bit and convert the property into a rental property before going through with the transaction. There's no hard and fast rule on how long the property must be a rental before the exchange can take place, but generally, the longer it is a rental the more likely it is that you'll be within the rules.

You can't access the cash. This is another important consideration. At no time can you take control of the proceeds of the sale from the first property. Ideally, you would be selling the first property and buying the second property at the same time. The money would go straight from one deal to the next. That's usually logistically difficult. The solution is to work with a 1031 exchange property specialist. They can hold your proceeds in escrow between transactions so you can stay compliant with the rule.

You must also consider mortgage gains. In some transactions, you may not actually receive cash proceeds. Let's assume that you sell the first property for exactly the amount needed to pay off the mortgage. Then you buy a second property with a much smaller mortgage. You didn't receive any cash, but in the IRS's eyes, you still experienced a gain. This reduction in mortgage could still be classified as a gain and could be taxed. However, if you follow the 1031 exchange rules, you could avoid any tax liability.

The 1031 exchange process can be complicated, especially if you've never been through it before. Work with a broker who specializes in 1031 exchange properties. They can help you stay compliant and minimize your tax liability.