Many investors are getting into real estate these days. Some are experienced and know what they’re doing; others are newbies. Either way, these investors have a lot to consider at tax time.
A 1031 exchange is an excellent tool for deferring capital gains taxes when it’s time to sell an investment property. But what, exactly, is a 1031 exchange? And why would you use it? Read on to learn what you need to know before going too far into investment property transactions.
What is a 1031 Exchange?
A 1031 exchange is a swap of one investment property for another. This transaction lets you sell one piece of real estate and reinvest the proceeds in another piece of real estate. Typically, this type of transaction would be taxable as a sale, but under a 1031 exchange, you can defer tax payment to some point in the future — as long as you abide by all the guidelines associated with a 1031 exchange.
How Does It Work?
A 1031 exchange involves selling your current property, identifying a replacement property, and then purchasing the new property with funds from the sale of the old property. The transaction is handled through a qualified intermediary, an independent third party with no ties to either the buyer or seller. This third party holds the money from the sale of the first property until the second property is located and purchased.
The benefit of this type of real estate swap is that it helps you grow your portfolio without the tax burden associated with that growth. There’s no limit to how many 1031 swaps you can do, but at the end of the investment period — when you’re ready to sell the final property for cash — you’ll pay taxes once at the long-term capital gains rate, currently 0%, 15%, or 20% based on your income.
Changes to the Tax Code
As of 2018, the rules for 1031 exchanges changed, stating that only investment and business property are eligible for a 1031 exchange. Prior to this, the rules allowed for other types of personal property in the exchange, including franchise licenses, yachts, artwork, and machinery. Personal residences don’t qualify, nor do vacation homes — except possibly in certain circumstances. Consult with a tax professional before leaping into this type of transaction.
A 1031 exchange requires that the replacement property be similar to the current property. The IRS calls this like-kind property. The new property must also be identified in writing within 45 days of the sale of the existing property, and the purchase must be completed within 180 days. The two timelines run concurrently, so once the clock starts ticking, it’s imperative that you keep moving. If any of these rules are ignored, or any part of the exchange is mishandled, you may lose the tax deferment benefit, resulting in a tax liability on the capital gains from the sale of the original property.
Why Use a 1031 Exchange?
The primary benefit of a 1031 exchange is to increase the overall value of your real estate portfolio while deferring taxes on that increase. For example, if you have a smaller rental property, you could use a 1031 exchange to sell it and purchase a larger, more valuable property that could provide you with more monthly rental income.
It’s a good idea to consult a tax professional before engaging in a 1031 exchange. The rules are complicated and have a lot of moving parts. A CPA will ensure that you’re following all the guidelines for a 1031 exchange and remaining within the bounds of the law so you don’t have any unpleasant surprises at tax time.
Call Adams Accounting Solutions for 1031 Exchange Advice
Adams Accounting Solutions knows all the rules and regulations involved with 1031 exchanges and can guide you through the process to make sure you get the full impact of the capital gains deferral. Give us a call with questions or to schedule a free consultation. We’re here to help!
