If you’re selling an investment property but plan to use the proceeds to buy another property, you may be able to defer the taxes owed on the capital gains.
It sounds too good to be true, right? But, it’s one way the IRS helps real estate investors, and it’s a benefit worth understanding. Let’s dive in!
What is a 1031 exchange?
Whenever you sell a property and earn capital gains, you’ll pay taxes on the earnings. This can deplete your profits and make it hard to invest in other real estate properties. But, with a 1031 exchange, you can defer the taxes you owe if you invest the capital gains in another like-kind property.
This doesn’t mean you get away without paying taxes. You’re deferring taxes rather than avoiding them. When you’re done with real estate investing or sell the property and don’t reinvest it in a like-kind property right away, you’ll pay taxes on the proceeds.
Who qualifies for a 1031 exchange?
Here’s what I love about the 1031 exchange—anyone can qualify as long as you own residential or business investment properties. You can own properties as an individual, partnership, limited liability company (LLC), corporation, or trust.
What are the 1031 exchange rules?
This is where things get tricky—the 1031 exchange rules are complex, but I’ve broken them down for you here.
Only real estate qualifies
Before the Tax Cuts and Jobs Act, other investments in things like equipment and aircraft counted in the 1031 exchange, but since 2017, only real property qualifies.
But what many people don’t realize is you don’t need to buy the same type of property. For example, if you sell an apartment building, you don’t have to buy another one. You could sell an apartment building and buy an office building or sell an apartment building and buy three properties.
The key is that you don’t receive cash from the sale. Instead, you reinvest it into another property.
There’s no limit
You can use the 1031 exchange as often as you want. There’s no limit to the number of times you can rollover your capital gains into another property. You won’t pay taxes until you sell for cash and don’t invest any longer.
You need a qualified intermediary
The intermediary or middleman holds onto your money between when you sell your property and buy the next property. When the money doesn’t touch your hands but remains with a third party, it’s considered a three-party exchange.
You have 45 days to identify a new property
Once you sell your property and the intermediary has the cash, you have 45 days to find and identify the property you’ll buy with the cash. You must inform the intermediary in writing of the chosen property.
Fortunately, you don’t have to settle on just one property. Instead, youFor example, most can choose up to three properties, and the 1031 exchange will take effect as long as you close on one of the identified properties.
You have 180 days to close
Once you sell your current property, you have 180 days to close on the new property to use the 1031 exchange rules.
You’ll pay the long-term capital gains rate
If you do it right, you’ll pay a long-term capital gains rate which is less than a short-term capital gains rate (your ordinary tax rate). Most investors pay 15% to 20% on their profits, but some pay as little as 0% depending on their income.
It only applies to business properties
You can’t use the 1031 exchange on properties you live in or even your vacation properties. The benefits are only for investment or business properties, such as buying an apartment building or even buying a single property as long as you rent it out.
Watch the depreciation recapture
Suppose you took advantage of the depreciation deduction on the property you are selling. In that case, you might have to pay your ordinary tax rate on the depreciation recapture if you aren’t careful.
Your tax advisor can help you determine if you owe depreciation recapture, but in general, it happens when you sell an improved property and buy unimproved property. You'll need to pay taxes on the depreciation.
You must finance the same amount or more on the new property
If you had financing on the property you sold, you’d need the same amount or higher financing on the new property to avoid taxation on the transaction.
Types of 1031 exchanges
Like most real estate transactions, there are a few ways to do a 1031 exchange.
Simultaneous 1031 exchange
As the name suggests, a simultaneous 1031 exchange occurs when you sell your current investment and buy another simultaneously. This works well when you have two investors who both want to take advantage of the 1031 exchange rules.
Partial 1031 exchange
The IRS rules allow you to offset the taxes on a portion of the transaction, but not all of it. If you need to cash out some of the funds earned on the sale, you can while deferring the taxes on the amount you transfer to another property.
The amount of cash you take in hand will incur capital gains taxes. You may also owe depreciation recapture. Any amount you reinvest in another property, though, becomes a part of the earnings you defer taxes on.
Reverse 1031 exchange
This isn’t something investors commonly do, mostly because they need the proceeds from the sale of their current property to buy a new property, but it happens.
In a reverse 1031 exchange, you identify and buy the new property before you sell the original property. Like the delayed 1031 exchange, you have 45 days from the day you buy the new property to state which property you’ll sell. You then have 180 days to sell the identified property and complete the transaction.
How to do a 1031 exchange
Every process will work a little differently, but here’s how to do a 1031 exchange in general.
1. Identify the property you want to sell
Remember, you can only use the 1031 exchange with investment or business properties, not personal properties.
2. Find a qualified intermediary to facilitate the process
Using a QI or exchange facilitator to oversee the process. The third party will ensure you don’t receive any cash (unless you’re doing a partial 1031 exchange). The QI will also oversee the sale of the original property and the purchase of the new property. Do your due diligence before choosing just anyone to be your intermediary—you need someone with financial intelligence who won’t squander your money and leave you with a large tax liability.
3. Identify the property you’ll buy
Inform the QI of the property you plan to buy, keeping in mind that it must be a business or investment property. It doesn’t have to be an identical property. Still, it must cost at least as much as you made on the original property to offset the tax liability.
4. Watch your deadlines
You have 45 days from the date you sell your property to identify a new property and 180 days from the date you sell your property to close on the purchase of the new property.
5. Complete IRS Form 8824
This is the form that tells the IRS you completed a like-kind exchange. You can file it with your tax returns.
The 1031 exchange rules allow you to defer taxes on any capital gains earned from investment properties if you immediately buy another property. It can be a great way to keep your investments growing without dealing with taxes right away.
The process can get complicated, and there are many gray areas. So, I highly recommend working with a reputable tax advisor to ensure you cover all your bases.