Though owning an investment property can be lucrative and rewarding, it also comes with its own unique set of challenges. One common struggle many real estate investors face is figuring out the best way to handle the sale of a property without incurring hefty taxes. This blog post covers everything landlords need to know about 1031 Exchanges, including when and how to use them, their benefits, and some important considerations to keep in mind.
What is a 1031 Exchange?
Named after the relevant section of the IRS tax code, 1031 Exchanges allow you to defer capital gains taxes on the sale of a property when the gains are reinvested into another qualifying investment property.
To qualify for a 1031 Exchange, the properties being exchanged must be considered "like-kind." The IRS guidelines consider any real estate property held for investment or used in a business to be like-kind. That means, a rental property can be exchanged for raw land if the raw land is held for investments.
There is no limit to the number of times you can complete a 1031 Exchange, enabling you to defer taxes forever by simply exchanging properties. Keep in mind that if any profit from the sale is not reinvested into another qualifying property, it can be subject to capital gains taxes.
When to use a 1031 Exchange?
Many investors choose to use a 1031 Exchange when they are ready to sell a property and upgrade to a larger or better-performing investment. Sure, you could go the traditional route and pay the taxes on the sale, but why not defer those taxes and potentially invest in an even more profitable property?
Here are some other common reasons to consider a 1031 Exchange:
If you have multiple smaller properties, you may sell them and use the profits to purchase a larger, single property. Paying taxes on each sale individually could significantly reduce profits so a 1031 Exchange can increase overall earnings.
A 1031 Exchange allows you to spread out your investments. If all of your investments are in the same market, you can use a 1031 Exchange to invest in multiple properties across multiple markets and reduce geographic risk.
1031 Exchanges can also come in handy if you're looking to upgrade one investment property to another one with higher potential earnings. For example, you may sell a home in the suburbs and use the profits to purchase a multifamily or commercial apartment building in a bustling city.
Defer taxes forever
You can use a 1031 Exchange to defer taxes forever, as long as you comply with the requirements. Moreover, when you pass away, the property's value will have a "step-up in basis" and taxes associated with the gain disappears. This means, if everything is compliant, your inheritors do not have to pay taxes on the gains.
What are the requirements?
Before completing a 1031 Exchange, you must consider some important requirements and considerations. Here's what you need to know:
As mentioned earlier, the properties being exchanged must be considered like-kind by the IRS. This means they must be used for investment or business purposes and can include any real estate (such as raw land, rental property, commercial buildings, etc.) Personal property, such as vacation homes, might not qualify for a 1031 Exchange. If you need more assistance here, consult a tax advisor or attorney.
For the exchange to be valid, you must use a qualified intermediary to facilitate the transaction. This neutral third party holds on to the profits from the sale until they are reinvested in a new property. They also handle all necessary paperwork to ensure the exchange is completed properly. Qualified intermediaries behave similarly to an escrow.
Without using a qualified intermediary, the investor could risk accidentally triggering a taxable event.
The 200% Rule and 95% Rule
The properties being exchanged must meet either the 200% or 95% rule.
- The 200% Rule states that the total fair market value of all properties being acquired in the exchange mustn't be more than twice the value of the property being sold. In other words, if you're selling a property worth $500,000, the combined value of the acquired properties must be no more than $1 million.
- The 95% Rule states that the total fair market value of all properties being acquired must be valued at at least 95% of the property being sold. So in our previous example, if you're selling a $500,000 property, the combined value of all properties acquired must be at least $475,000.
According to the IRS, a 1031 Exchange must involve a minimum of two properties: the property being sold and the one being acquired. You can use the exchange to acquire a maximum of three additional properties. This is known as the three-property rule. It's important to note that while you can choose to acquire up to three properties, you are not required to do so.
While a 1031 Exchange can defer capital gains taxes, it does not exempt you from depreciation recapture. This means that any depreciation deduction taken on the property being sold must be paid back at the time of the sale.
Read Nophin's depreciation blog to learn more about this!
Timeline for a 1031 Exchange (45 days, 180 days)
When using a 1031 Exchange, you must also adhere to a strict timeline. Within 45 days of selling the original property, you must identify any potential replacement properties. Once you find the property, you must designate it in writing to the qualified intermediary.
Then, within 180 days of selling the original property, you must close on the replacement property or properties. Any profits from the sale that have not been reinvested by this deadline will be subject to capital gains taxes.
Note that both of these deadlines run concurrently, so it's important to plan ahead and stay on top of timelines.
Overall, a 1031 Exchange can be a valuable tool for real estate investors looking to defer capital gains taxes. Before starting the process, consult with a tax advisor or attorney to ensure the exchange is completed correctly.
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