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What is a 1031 Exchange and how does it work?

What is a 1031 Exchange?

A 1031 exchange can be described as a like-kind exchange and is named after section 1031 of the IRS code. Many successful real estate investors use a 1031 exchange to defer paying capital gains taxes on an investment property when it is sold. There are however various timelines and processes you must follow into order to do this. A similar property must be purchased from the profit gained by the sale of the first property in order to avoid capital gains taxes within 180 days. The subject property must be named within 45 days of the sale of the first property. See the example below to show you how a 1031 exchange works.

1031-exchange

How does a 1031 Exchange work?

For example Let’s say you made a $100,000 profit on the sale of rental property, for which you will incur $35000 in capital gains taxes. You would then only have $65000 left to roll into another property. If we then assume you will need to put 25% down on the new property and that the mortgage-to-value ratio is 75%, you would only be able to purchase another property with a value of $260,000 or less.

However, a 1031 exchange would allow you to defer the $35000 tax liability, giving you $100000 to reinvest in the purchase of a replacement property. Given the same assumptions regarding the down payment and mortgage-to-value-ratio as above, you would then be able to purchase a replacement property with a value of $400000, rather than the $260000 property you would be able to afford otherwise.
What this example demonstrates is that a 1031 exchange can allow you to build wealth faster by keeping all your money working for you instead of going to taxes.

If you are in the Disney area and are thinking of selling your vacation home please contact one of our realtors at Top Villas Realty on 407-495-2595. We specialize in helping our clients buy and sell investment homes and often work with investors doing 1031 exchanges. Please be aware that Vacation and second homes used by the investor for primary use with no rental activity are simply just a second home and will not qualify for a 1031 exchange. If you are not renting it out and wish to do so please contact our reservation team at Top Villas on 407-495-2595. We are the largest reservation agent for vacation homes near Disney World

In order to meet the minimum guidelines for a 1031 exchange the property has to have been owned for at least 24 months and rented out for more than 14 days per year at fair market value for the 2 years before the sale. The investor has limited their personal use to no more than 14 days during the preceding 2 years or 10% of the number of days that the subject property was rented out at fair market value.

It is important to make sure you keep good records of all of your income and expenses when owning a vacation home that you will use for a 1031 exchange. If you have gone to the home to do upgrades yourself such as laying a new floor, painting the house, or other maintenance items then these days will not be included in your personal allowance of days used.

Before proceeding with a 1031 exchange we would always advise you to contact a professional for advice.

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