If you are a real estate investor, there’s a good chance you will need to sell a property at some point. Typically doing so would result in having to pay capital gains tax on your investment, but that doesn’t have to be the case. By using a 1031 exchange, you can defer paying capital gains taxes on the sale of your property.
In this article we go over the basics of a 1031 exchange and answer the following questions:
⦁ What is a 1031 exchange?
⦁ How does a 1031 exchange work?
⦁ What qualifies for a 1031 exchange?
What is a 1031 Exchange?
A 1031 exchange is arguably the most valuable tax advantage available to real property owners. Stemming from section 1031 of the Internal Revenue Code
, a 1031 exchange allows a property owner to avoid paying capital gains tax on the sale of their property by investing the proceeds into a “like-kind” property within a specified time period.
For example, say you purchased a property five years ago for $100,000 and are now selling it for $300,000. Because you made a gain of $200,000 on your investment, that amount will be subject to capital gains tax
. However, if you use a 1031 exchange to purchase another property with those funds, you can delay paying the capital gains tax. This would allow you to utilize the buying power of the full $300,000 (less any transaction fees not accounted for in this simplified example), which is why a 1031 exchange is such a useful tool.
There are pros and cons to a 1031 exchange, and it may not always be the right option for every situation. Our experienced team at Marzo Capital Group can answer any questions you have and help decide if a 1031 exchange is right for you.
How Does a 1031 Exchange Work?
There are a few steps and timelines you must follow in order to conduct a 1031 exchange. Following them correctly will allow you to defer paying taxes, but doing them incorrectly can result in a lot of headache and an unwanted tax bill.
The first step in a 1031 exchange is to sell a property. Once the property is sold, you will have 45 days to identify the property you intend to purchase, and 180 days to close on the property. If you are unable to meet those deadlines, you will likely not be allowed to perform a 1031 exchange.
Once you’ve sold the original property, the funds must be given to a Qualified Intermediary (QI)
who will hold the funds until the 1031 exchange is complete. The QI will be entrusted with holding a significant amount of money for an extended period of time, so take extra care to select a QI that you trust.
When you have identified the replacement property and are ready to close, the QI will supply the funds for the transaction and allow you to acquire the new property. At this point you will have successfully completed the 1031 exchange.
There are a number of caveats and specifics to this process that are beyond the scope of this article, so we recommend you consult with an expert before jumping into the process.
What Qualifies for a 1031 Exchange?
Aside from the specific steps and timelines required for a 1031 exchange, the other primary requirement is that the property you are selling and the one you are buying must be “like-kind” properties.
A lot of people assume that the like-kind property requirement means that if you sell an office building you can only buy an office building, or that an apartment complex can only get you another apartment complex. However, that is not the case. The like-kind requirement simply means that you must exchange one form of real property for another.
In general, office buildings, warehouses, retail centers, land, multifamily and single-family rentals will all qualify for a 1031 exchange. Even more obscure assets like mineral, water or air rights can qualify, as well as easements and development rights.
We hope this article helped shed some light on what a 1031 exchange is and how you might be able to use it as a part of your real estate investment plan. Although the process can be complicated at times, having the opportunity to defer paying capital gains taxes is well worth the effort.
Of course, there are many specific details we were not able to cover in this article, so do your research and consult with experts before jumping into the process.
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