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1031 Exchange – What is a 1031 Exchange?


In Hawaii, and especially in Maui Real Estate, the 1031 exchange is a very popular and common way to purchase real estate.

You can defer paying capital gains tax on the sale of an investment or business property if you use the proceeds of the sale to purchase a similar property, replacing the one you sold. This replacement property needs to be a property used for the purpose of business or investment. It could be an office building or an apartment building. It could be a rental or it could be land for development. The one you purchase has to be the some kind of business or investment property. 

You can benefit greatly from this type of an exchange. For example:

You can defer your capital gains! You must use all of the proceeds from the property you sell toward the purchase of another property. Just like many supermarket sales, the second one must be of equal or greater value. The good news? You don’t have to pay capital gains tax on the sale of the first property, so you have more capital to work with!

If  you have an investment property that isn’t quite working out for you, or if you have found an investment property in a better location, or just a better property, you can improve your real estate investment portfolio without paying capital gains tax.

There are some people you may wish to consult before initiating a 1031 Exchange.

You will definitely want your tax advisor to establish market values for the properties you wish to sell and purchase. You will also want to have them allocate sales and purchase prices, and advise you on how to structure your transaction.

You will need to find a third party entity well versed in exchange proceedings, this is required by the Treasury Regulations. The exchange professional prepares any documentation needed for the exchange, consults with your tax advisor, executes the closing documents, conducts the exchange proceeds, and coordinates between the various parties involved.

A real estate professional is also preferred to help find a buyer for your current property and to help find the best value for your new, exchange property.

Do you qualify?

You have to meet three specific criteria In order to qualify for a 1031 Exchange of real estate:

First, the property that you are selling and the property you are purchasing must be done so for use in a trade or business or for the purpose of investment. You cannot “flip” the property you intend to purchase.

Second, real property must be exchanged for real property, you cannot exchange it for any personal property.

Third, in order to qualify for 100% capital gains tax deferral, you need to purchase a replacement property equal to or greater than the SALES price of the property you are selling (less commissions and escrow fees). Otherwise  you will owe the capital gains tax for the difference. Also, the ownership must remain the same. If a husband and wife own the property being sold, they must also be the registered owners of the replacement property.

There are four different exchanges possible.

1. Delayed Exchange – A Delayed Exchange gives you 180 days between selling your original property and purchasing a new property. In the interim, the exchange professional holds the funds from the sale of the original property. This prevents you from having actual or constructive receipt of the funds, since that would invalidate the 1031 Exchange as you could invest those funds during this time.

2. Reverse Exchange – A Reverse Exchange is what happens if you purchase the replacement property before you sell the oroginal property. The lender, or the buyer, sends funds to an Exchange Accommodation Titleholder (EAT), who purchases the new property. Once your oroginal property sells, the exchange professional uses the funds to purchase the new property from the EAT. At this point, the EAT uses those funds to pay back you or your loan.

3. Simultaneous Exchange – This one should be obvious. Both transactions happen at the same time. However, the law states you still must have an exchange professional involved.

4. Improvement Exchange – This means you want to make improvements on the property you are buying to replace your original property. This is completely fine, you just need to have the improvement completed withing 180 days of the sale of the original property.

If you think this may be an option for you, call us to talk about selling your property, finding a replacement, and all the details in between.

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