More than 70 percent of rental properties are owned by individual investors. Real estate investing can be a highly profitable industry, but leveraging every advantage is imperative.
If you are considering selling a property to buy a similar one, you may have come across the concept of 1031 exchanges. These are a way to defer paying capital gains taxes, as long as you meet certain stipulations.
While this may sound complex, the process is pretty straightforward, as long as you understand all the requirements. The guide below will walk you through the ins and outs of 1031 exchanges. Keep reading to find out how to make the most of this investment tool.
What Is a 1031 Exchange?
1031 exchanges refer to a condition in the United States tax code (Section 1031) that allows business owners and investors to defer paying capital gains and depreciation recapture taxes on the sale of certain types of investment properties.
The main advantage of 1031 exchanges is that they allow your capital gains to grow tax-free. They have the added benefit of letting you shift to a more profitable real estate investment without penalty.
Note that 1031 exchanges are a deferment, not a complete avoidance of taxes. Whenever the new investment property is eventually sold, a long-term capital gains tax is paid. This is usually between 15 and 20 percent. Also, there is no limit to the number of 1031 exchanges a single investor can make.
What Are the Requirements for 1031 Exchanges?
You must meet several requirements to be eligible for a 1031 exchange. First, they are only for business investors. The provision is not available to homeowners who are buying or selling personal property as their primary residence.
The second main requirement is that the exchange must be for “like-kind” property. That means that the two properties must be the same type––two apartment complexes or two single-family homes. Note that they do not have to be identical in value or quality.
The third big stipulation is that 1031 properties cannot result in a cash payout. The investor cannot receive any funds from the sale of the first property. They must be held by a third party and then immediately invested in the new property.
The final requirement is that 1031 exchanges must be within a strict timeline. The second property must be designated within 45 days from the sale of the first property. The second closing must be no more than 180 days from when the first property was sold.
How Do You Start a 1031 Exchange?
The first step to getting the ball rolling on a 1031 exchange is to find the taxable worth of the property you sold or plan to sell. This is the original price plus any value gains or fees, such as closing costs. This information can help you plan for the exchange.
As mentioned, the process requires a “qualified intermediary” (QI) to hold the funds from the sale of the first property. These are tax professionals that will make sure all requirements of the 1031 exchange are met.
Look for someone who has comprehensive insurance, a lot of experience with 1031 exchanges, and access to qualified escrow accounts. Unless the sale of both properties happens on the same day (which is unusual), you need to hire a QI.
The final step in the 1031 exchange process is to alert the IRS of its existence. This involves filing Form 8824 with your taxes for the year during which the exchange occurred.
Learn More About 1031 Exchanges
We hope you found this real estate guide on 1031 exchanges helpful. It can help you decide if this mechanism is the best route for you. Contact us at Marketing@homeriver.com to learn more.