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When you sell your primary personal residence, the home sale capital gain exclusion can eliminate or severely limit your capital gains tax liability. When you sell an investment home, though, the Internal Revenue Service hits you with both capital gains and depreciation recapture taxes. However, if you sell your property, use the proceeds to buy more investment property, and structure the transaction as a Section 1031 tax-deferred exchange, you can defer paying taxes until you sell your 1031 exchange property for cash. Note that 1031 exchanges have many rules, including a requirement that you close on your replacement property within 180 days of the sale.
If you sell your personal residence, and if you lived in the home for two of the past five years as your primary residence, you can take advantage of the home-sale capital gains exclusion. As long as your profit is $500,000 or less if you are married and file jointly or $250,000 if you file a single return, your entire capital gain is excluded from taxes. To take advantage of this, you don't even have to reinvest your sale proceeds. You can do whatever you like with the money.
1031 Exchange Basics
If you sell investment property, a different set of rules applies. A 1031 tax-deferred exchange, also known as a Starker exchange, is a special transaction structure that lets you sell property, buy more property and not pay capital gains or depreciation recapture tax at the time of the sale. To accomplish an exchange, you hire a third party, called a qualified intermediary, who signs the contracts and holds the money. Since you never actually receive any money, the IRS doesn't treat it as a sale. Instead, you just carry your cost basis forward as if you had never sold your original property.
For a 1031 exchange to be valid, you must buy a replacement property that is "like-kind" to your relinquished property. Any piece of investment real estate in the United States is like-kind to any other US-based investment real estate. In other words, the proceeds from the sale of your rental home in Schaumburg, Illinois, could be exchanged into a beachside condo in Sanibel Island, Florida, a small industrial building in Saugus, Massachusetts, or a tenant-in-common share of a retail center in Santa Ana, CA.
1031 Exchange Closing Rules
One of the most basic rules of the 1031 exchange is that you have to close on the purchase of your replacement property within 180 days of the closing of your relinquished property. Having the replacement under contract is not adequate -- it most close. If you are even one day late, the IRS can disallow your exchange. You can of course close before the 180th day if you desire.
1031 Exchange Identification Timeline
Long before closing, you have to submit a written and dated list of the properties that you want to buy to your qualified intermediary. This identification list has to be finalized within 45 days, although you can submit it earlier and revise it up to that date. Generally speaking, investors list three properties that they are willing to buy and buy any one, two or three of them. If you buy a property that is not on your identification list or if you fail to submit an identification list, the IRS will disallow your exchange if they audit you and find out about it.
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