What is a 1031 Exchange, and How do I Get Started?

What is a 1031 Exchange, and How do I Get Started?

Chicago is a city that's always under development. Whether you're looking at the skyscraping condos downtown, the numerous single family homes under construction in Bronzeville, or the many rehab projects happening right now in Uptown and Lincoln Square, Chicago is constantly growing and changing right before our eyes - and for those with a keen strategy in place, it may be a lucrative time to invest in real estate.

Fortunately, there are numerous protections in place to encourage developers - and aspiring real estate tycoons - to invest their time, energy, and money in Chicago real estate, without having to worry about the burdens of property taxes.

Looking to invest in Chicago real estate for profit? Then there’s one process you need to know upfront: The 1031 exchange. In simplest terms, a 1031 exchange allows you to defer paying taxes on the appreciated value of a property by putting it right back into another investment vehicle of equal or greater value.

To explain this interesting piece of tax law, let’s start with an example of why it’s so necessary to investors.

When an everyday consumer buys a home – solely for the purpose of living there – that property will likely appreciate in value, and the homeowner may want to sell in the future. Let's say it goes up $200k over a period of years. Like anything else bought or sold, your home is a good that is taxable.

However, because of what’s known as the homestead exemption, in place here in Illinois (and in most states), this homeowner likely wouldn't have to pay taxes on their sale. Put simply, the logic is that if the property is your home, then you've necessarily got to move somewhere new once you sell; the homestead exemption allows you as a homeowner to more or less roll any earned money forward to a new property.

An investor who doesn’t rely on their property as a dwelling, however, is not protected by this exemption, which may initially take some of the shine off investing. That’s where the 1031 exchange – so-called for section 1031 of the Internal Revenue Code (IRC) – comes in.

As an investor taking advantage of a 1031, you’ll still have to pay taxes on appreciation, but not more every time you transact. What do we mean? Let’s say you purchase and rehab a two-flat, then rent it out to tenants. Once this building goes up in value, you want to sell it, in order to buy a new building, which costs more than the prior one.

What you can do is time the sale of the two properties in such a way that you can avoid paying taxes on the appreciation, thanks to 1031. Investors have a total of 180 consecutive days – beginning on the day of the sale of the relinquished property - to complete a 1031 exchange.

There are some other caveats. For instance, within the first 45 days of that 180-day period, investors must identify up to three replacement properties, of any value. Only these properties qualify for the 1031 exchange, but you can identify more than three properties, with some stipulations attached. Many types of investment properties are covered by 1031 exchanges, including land, commercial real estate, single family homes, multi-family homes, and condominiums, and you don’t have to swap the exact same type of property, one-to-one (i.e., you can exchange a commercial property for a piece of land). The most important thing to remember is that the property must be held for investment or business use only; primary residences and secondary homes do not apply.

After identifying their replacement properties by day 45, the investor then has until day 180 to close on all of the intended replacement properties. The investor must bring on a qualified intermediary – who may not be a real estate broker or financial advisor – to successfully complete the exchange.

With some strategic thinking, an investor or developer may never have to pay taxes on the appreciated value of their investment properties – as long as he or she follows the 1031 exchange rules every time they sell one property and buy a replacement.

Have any more questions about the ins and outs of real estate in Chicago? Real Group is here to help! Drop us a line in the contact form below to get started.

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