How You Can Avoid Paying Taxes with a 1031 Exchange
What is a 1031 exchange?
“In this world, nothing can be said to be certain, except death and taxes,” said wise Benjamin Franklin. Well.. that was before the 1031 tax exchange bill. Before you sell that investment property, wait up, and read this article because you could be saving yourself some Benjamins!
A 1031 tax-deferred exchange is defined under section 1031 of the IRS code. A 1031 tax exchange is a process in which property owners can defer payment of capital gains taxes of an investment property by reinvesting the proceeds from that sale on another “like-kind” property within a certain timeframe.
Capital Gains Taxes
When you make a profit on the sale of a property, uncle Same will ask you for a piece of that pie in the form of, you guessed it, taxes. If you sell a property that is not the primary residence that you’ve held for at least a year, you are responsible for paying capital gains taxes on the profit and could be up to 15% of the sale price. They are calculated based on the difference between the sale price and the original price you paid.
In order to avoid paying taxes, the property must be transferred to a “qualified intermediary”, which can be another person or company that helps facilitate the exchange of the property by holding the funds until they can be transferred to the seller of the new property.
What Are the Benefits of a 1031 Exchange?
The main and most obvious benefit is the tax savings. With a 1031 exchange, you can defer on paying capital gains taxes (sometimes forever if you do it right!) which frees up your capital so you can invest in a new property and continue building wealth. Sounds amazing right? It is!
How To Choose a Replacement Property- Timing and Rules
1. LIKE-KIND PROPERTIES
Like-kind properties have more to do with their purpose and less to do with their physical aspects. In order to qualify a like-kind property, both properties being exchanged must be used for business or investment purposes. In addition, like-kind property “must be of the same nature or character”, even if they differ in grade or quality. To put it another way, you can’t exchange a John Deer tractor for a duplex because they’re not the same asset. Seems obvious, but the law doesn’t allow for misinterpretations! However, you could exchange a single-family home for a condo, or a larger property for multiple smaller ones.
Just make sure both properties being exchanged are within the United States in order to qualify for a 1031 exchange.
2. GREATER OR EQUAL VALUE
The rule says that in order to defer 100% of the tax, the new property purchased must have a value that is equal to or greater than the property being sold. You also have to reinvest all of the money you receive from the sale into the new property (closing costs and broker fees go towards this price).
3. PROPERTIES MUST BE INVESTMENT OR BUSINESS PROPERTIES (NO RESIDENCES ALLOWED!)
You may use a 1031 exchange for investment or business purposes only. To give you an example, if you move from Alabama to California, you may not swap out your house in Alabama for a new one in California. (I wish it were that simple!). But you could exchange a single-family rental in Alabama for a condo in California. See how that works?
4. MAY NOT RECEIVE “BOOT”
Let’s say you sold your property for $200,000 and you exchange it for another that is $150,000 (50k less). You would have to pay capital gains taxes on the $50,000 difference, also known as “the boot”.
5. SAME TAXPAYER
In a 1031 exchange, the taxpayer who owns the relinquished property must also be the same titleholder who takes ownership of the new property. If you own a single-member limited liability company (smllc), you may use that company you own as the new titleholder and still be in compliance with the 1031 exchange code.
6. 45 DAY IDENTIFICATION WINDOW
This rule says that the seller of the relinquished property has 45 days from the date of sale of the relinquished property to find up to 3 potential replacement properties.
Exceptions to the Rule ->200% Rule – If you want to identify more than 3 properties, you can use the 200% rule. The 200% rule states that you can identify any number of properties as long as the total value does not exceed twice the market value of the relinquished property.
7. 180 DAY PURCHASE WINDOW
The exchange must be completed no later than 180 days after the sale of the relinquished property or the due date of your Federal income tax return for the tax year in which the relinquished property was sold, whichever comes first.
Summing it Up
As you can see, there are many rules and intricacies to the 1031 exchange that might intimidate even the most seasoned investors. If you acquire a property at a loss because it was a poor investment, you’re still responsible for paying taxes on the relinquished property and this could spell out financial ruin. It is critical that you have a firm understanding of the ebbs and flows of the real estate market, and general real estate investing before getting started in real estate. But, if you take time to educate yourself and work with a reputable exchange facilitator, you may avoid paying thousands in taxes and create substantial wealth too!
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