If you’re a real estate investor in Phoenix, Arizona, it’s important to understand the city’s most important real estate terms, laws and ordinances. This includes certain tax laws that may affect your investment.
For example, you may be planning to sell your property in Phoenix. If so, you should be familiar with the 1031 tax-deferred exchange and understand how it works so you can use it to your advantage.
At Taylor Street Property Management, we believe understanding the 1031 exchange laws are a great tool an investor has their disposal. Which is why we have put together the following article.
What Is a 1031 Exchange?
A 1031 exchange is a method of exchanging one property for another property. The term “1031” is derived from Section 1031 of the Internal Revenue Code (IRC), which is the provision that made this procedure legal. Successful property investors use this method to defer paying capital gains taxes or pay taxes from another source, when they sell their investment properties.
For example, if you sell your Phoenix real estate property through a 1031 exchange, you may temporarily avoid paying for the capital gains tax. But there’s a catch, you are only allowed to do this if you use the proceeds from the sale to buy another property.
Keep in mind that this method is only available to business owners investors and property owners. It is not available to those who buy and sell a real property for personal use.
Why Is a 1031 Exchange Important?
The 1031 exchange is a smart investment strategy, as well as a wise tax and estate planning method and a great way to improve your ROI. It allows Phoenix real estate investors to build their portfolio, diversify their investments, and grow their wealth.
Using the 1031 exchange when selling your Phoenix business or investment property is important because it can help you defer the payment for high taxes, which could go from 15% to 30%.
This method allows you to use the full proceeds generated from your sales to buy a new investment property in Phoenix. You can also defer paying taxes to pay for necessary improvements that will add more value to your income property. Then you can use your new asset as a rental property and earn passive income. It’s worth noting that capital gains tax on your personal property is only deferred temporarily.
What Properties Eligible for a 1031 Exchange?
Only properties that are used for business or as an investment can qualify for 1031 exchange. Private residences are not qualified. So, if you plan to take advantage of the 1031 exchange for your Phoenix investment, you need to make a “swap”. This means that the business-use or investment property should be exchanged for another business-use or investment property.
Fix-and-flip properties are often not qualified for 1031 exchange as they would require you not to defer capital gains taxes. As fix-and-flips are only bought for the purpose of reselling. Purchasing investment properties for resale is prohibited under the 1031 exchange rules.
Moreover, second homes and vacation properties that are not rented out typically cannot qualify for this tax-deferred state. But there is a provision under Section 280A of the code that may allow these types of properties for 1031 exchange. It’s best to consult with a tax specialist in Phoenix regarding your personal property, if you are not sure about this.
Important Aspects of a 1031 Exchange
To qualify for a 1031 exchange in Phoenix, you need to comply with all of its rules and requirements. Here are a few of the important things that you need to know and understand about the 1031 exchange. If you have any questions regarding this or the replacement property, its best to talk to a professional or qualified intermediary:
One of the most important requirements for the 1031 exchange is that the property qualifies, so the new one should be for business or investment purposes, such as an office building. This refers to “like-kind” relinquished property. This means that you cannot use land that is being developed for resale.
You can exchange raw vacant land for an investment property like a shopping center. Also, you, with the help of a qualified intermediary, could swap, for example, an apartment building for a farm or commercial real estate. There are several potential combinations including exchanging one or more properties can work under the 1031 exchange tax code rules.
The 45-day rule for identification is one of the most crucial restrictions for a 1031 exchange. If you’re selling an property in Phoenix, you should choose a new property and identify it in writing within a 45-day period.
The 45-period will start from the date of closing and transfer of the original property, including weekends and holidays. This time period is non-negotiable in Phoenix and everywhere else in the country.
If you fail to meet this deadline, your exchange for the new property will be disqualified, and you will have to pay the capital gains tax and all other taxes associated with the sale of the new property.
Three Property and 200% Rules
The three-property rule allows Phoenix investors to identify three properties without the need to consider their fair market value. In addition, the 200% rule allows you to identify several properties.
This is allowed as long as the aggregate fair market value does not go over 200% of the relinquished property’s fair market value on the transfer date.
If both the three-property and the 200% rules are exceeded, the exchange may still be approved. The exchange may be saved if the taxpayer buys identified replacement properties. Additionally, the fair market value of such properties is at least 95% of all replacement properties’ aggregate fair market value.
Reversed 1031 Tax-Deferred Exchange
A reverse 1031 tax-deferred exchange is almost similar to a regular 1031 exchange transaction. However, instead of selling the old property first, an investor purchased a replacement property before the old one is sold. This is what makes it a transaction “reversed.” If you have any questions about this, its best to contact a professional or qualified intermediary.
The 1031 tax-deferred exchange is a great way to maximize your sales proceeds to improve your new property. This method is useful if you need to delay paying taxes. If you’re in Phoenix and you’re planning to sell your property, it’s best to work with a professional to guide you on this process.
Fortunately, we at Taylor Street Property are a qualified intermediary can help you with managing your rental property, as well as provide assistance on 1031 exchange transactions.