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How Does a 1031 Exchange Work

It is a requirement that you pay capital gains tax when you sell a non-inventory asset at a profit. However, there exist exemptions that allow individuals and corporations to defer tax payments in certain circumstances. For instance, you will need to pay tax on the disposal of property if there was a profit somewhere. For the exemption to work, you will need to use up the proceeds from the sale to purchase another property within a certain period. With such a simple swap, the payment of capital gains tax is deferred As simple as it sounds, there are certain conditions that you must meet to take advantage of it and they are discussed next.

The new or replacement property must be held so as to take advantage of the exemption. That means you will be liable to pay tax if you sell the property at a later date. One desirable aspect is that you can defer the payment of capital gains tax indefinitely by swapping properties now and then.

Since the exchange involves business and investment property, you cannot benefit from an exemption if you intend to swap a residential building. So, swapping your home will not work since you will be liable to pay capital gains tax to the authorities. Vacation homes are different but the application of the exemption takes place in the presence of certain circumstances that are quite cumbersome for most people to fulfil.

You are allowed to do a delayed exchange since it is difficult to find someone with the property you desire and who wants the type you have to swap. For the delay to be effective, a middleman is needed to hold your funds, after which he purchases the property you wish to buy in your place. Even with third party involvement, a swap is still considered to have taken place.

A valid swap is one that involves the identification of the “replacement property”. Also, it is essential that you identify it in writing, append your signature to the document, and ensure that 45 days do not pass before you deliver it to your qualified intermediary.

It is only when you meet the like-kind requirement that the exchange will be deemed to be valid. Here, you have to acquire an asset of the same type for this rule to apply, meaning that you can defer capital gains taxes if you sell raw land and acquire a shopping complex.

The involvement of experts is necessary for a successful exchange to take place. The reason is that tax laws are complex and innumerable, making it easy to mess things up. Also, these rules change with time, making it essential to hire someone who keeps up with such updates. An estate agent, attorney, accountant, and tax specialist can help you navigate the complexities involved.

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