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1031 Exchange and How It Works with Rental Properties

Rental properties offer a lot of great benefits, including IRS tax benefits. You will be able to depreciate rental properties to save taxes, and a 1031 exchange lets you sell rental properties and defer taxes on whatever profit gained or recaptured depreciation.

But what is a 1031 exchange and how does it operate? In a real estate transaction known as 1031 exchange, two properties are involved: one which is being sold and one which is being purchased over a definite time frame. There are so many limitations on a 1031 exchange, but the IRS is not that clear when describing them. Some core principles are that the properties should have been possessed by the owner for no less than a year and be used for a business purpose; and the replacement property should be identified in 45 days and purchased within 180 days. If such requirements are complied with, a rental property could be sold without any taxes on the profit made or recaptured depreciation.

Taxes Owed without a 1031 Exchange

Selling a rental property entails taxes to be paid on any profit that you make from the sale. Also, recaptured depreciation may have to be paid. The IRS permits you to depreciate a rental property since they feel a structure will have a short life span and decrease its value yearly. You can subtract that depreciated amount from your annual taxes, which is a significant bonus to anyone who owns rental properties. But if you decide to sell the rental property for a price that exceeds the depreciated value, you will have to pay back any taxes you saved.

Properties Suitable for a 1031 Exchange

A 1031 exchange may be used on several types of real estate properties. Any property that is used for business may be used for a 1031 exchange as well, including rental properties. It can even be used on mineral or water rights.

The following though cannot be used:

> Stock in trade or all properties that are held firstly for sale

> Bonds, notes and stocks

> Other securities or proof of interest or indebtedness

> Partnership interests

> Trust or beneficial interest certificates

> Choses in action (a right to something, like payment of debt)

Reverse 1031 Exchange

Investors usually sell a property they own and then buy a replacement property. It’s also possible to pay for the replacement property before you sell your original property. This could be a tough move since the investor will not have the money from his original property’s sale.

It may work though for an investor constructing a replacement property that can be exchanged into. The time needed for building and purchasing a property might be in excess of 180 days, which is the reason investors may do a reverse exchange.

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