You may have heard the term before in the Real Estate world, but what does it mean exactly?
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like-kind and equal or greater value.
Phew, that's a mouthful! Basically, it's a way for you to sell an investment property and instead of paying tax on the gain (long term capital gain rates if owned more than a year, short-term capital gains rates if owned for a year or less), you instead defer the gain to a future point in time by investing the funds into a similar or "like-kind" property.
If you are considering this as a tax savings option for yourself or your business, I highly recommend using a qualified intermediary to facilitate the exchange.
A Qualified Intermediary (QI) is someone a property seller selects to oversee the 1031 exchange process and its funds. They hold the funds from the previous property and use them to acquire the new replacement property to ensure compliance with IRS regulations.
You must identify the new property within 45 days of the sale of the original investment property, and you must close on the purchase of the new property within 180 days in order to qualify for the tax deferral.
This isn't tax forgiveness, you are simply deferring the gain to a future point in time. However, this can be a great strategy to build wealth and equity, since deferring the gain allows you to keep more of the profits and invest them back into another property.
If you end up holding on to the property until you die, the heirs of your estate inherit the property with what is called a "step up in basis", which means they inherit it at the current fair market value as of the date of death, and if they were to sell the property immediately they would owe no tax on the transaction.
There are also ways to sell your investment property and invest the funds into a REIT (Real Estate Investment Trust) or DST (Delaware Statutory Trust) if you want to take advantage of the deferred tax treatment without the hassle of personally owning or managing another investment property. If you would like a referral to experts who specialize in this type of investment tool, please reach out to us. We have some incredible referral partners that can help you in all areas of your real estate investing journey.
The 1031 exchange is often confused with the sale of your primary residence. Personal use property does not qualify for the 1031 exchange, however, if you own and live in your primary residence for at least two out of the last 5 years before you sell, you qualify to exclude up to $250,000 in gain every two years. The money does not need to be invested into another property in order to qualify for this exclusion, you simply must meet the ownership and use tests determined by the IRS and not have taken the exclusion within the last two years.
If you would like to discuss the possibly of using real estate as a tax savings and wealth building tool, we would love the opportunity to help. We offer online virtual tax advisory sessions where we can answer your questions and even run planning scenarios to see how much you could save in taxes by buying or exchanging investment properties.
More information can be found on the IRS website: https://www.irs.gov/pub/irs-news/fs-08-18.pdf
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