With many buyers purchasing second homes on Kauai, a 1031 exchange is a great way to save taxes when purchasing a vacation rental property. Here are a few of the most frequently asked questions!
What is a 1031 Exchange?
A 1031 Exchange refers to a real estate transaction realized under the rules of Section 1031 of the Internal Revenue Code in order to defer relevant taxes until a future date. (Section 1031 provides that no gain or loss shall be recognized for tax purposes on the exchange of property held for productive use in a trade or business, or for investment.) A typical transaction involves a property owner trading a property for another "like kind" replacement property. The IRS sees the transaction as having reinvested the sale proceeds into another property thus no economic gain has been realized that would generates the funds to pay the taxes.
What are the benefits of a 1031 Exchange?
A 1031 exchange enables the property owner to defer or completely eliminate potential taxes associated with the sale of real property. By deferring the taxes the owner has more money available, on an interest free basis, to invest and thus can afford a more expensive property then otherwise would be affordable.
What does "like Kind" mean in a 1031 Exchange?
A tax deferred exchange that allows for the disposal of an asset and the acquisition of another similar asset without generating a tax liability from the sale of the first asset. You are replacing one real estate investment property for another property.
How does this actually work?
Section 1031 allows for the sale of a property with the proceeds going to a "qualified intermediary" who then holds the funds until the replacement property if ready to be purchased. This is what makes a 1031 Exchange official. You must let your selling agent know that you intend on selling this as a 1031 exchange.
What are the deadlines/timelines involved?
From closing on the sale of the relinquished (sale) property, an Exchanger must:
- Properly identify potential replacement properties within 45 calendar days (the"Identification Period")
- Close on the replacement properties within 180 calendar days of the relinquished property sale - OR - the due date (including extensions) for the Exchanger's tax return for the taxable year in which the reliquished property was tranferred, whichever is earlier (the "Exchange Period")
In short, 45 days to identify and 6 months after to close.
What is a "Qualified Intermediary"?
A Qualified Intermediary (also known as an Accomodator) is a person or entity that hold the funds received from the sale of the relinquished property in escow, until the replacement property is purchased; thereby ensuring that the rules around Section 1031 are abided by.
What types of taxes can I defer?
A 1031 exchange allows for the deferment of Federal, and in most cases state, capital gain and depreciation recapture taxes.
Do I have to spend all my earnings on the next property?
No. You tell the closing officer on the property you are selling to send the facilitator how much you want to 1031 and the rest you claim as capital gains.
What does not qualify for a 1031 Exchange?
Any of the following do not qualify: Stocks, bonds, loans, partnership interests, personal residences, and certificates of trust.