In real estate investing, you already know that what you don’t know can really hurt you.
This is perhaps no more true than when you’re selling a property. You could end up paying capital gains that slash your ability to accumulate wealth over the life of your investments. Capital gains could cost you as much as 28%.
Fortunately, there’s a perfectly legal way to defer these taxes so that you can reinvest the money now to grow your business.
Let’s learn what you need to take advantage of a 1031 exchange.
Time Is Of The Essence
Finding the perfect 1031 exchange property for sale at the right time isn’t always easy. Investment property isn’t like buying a car. Every one of that “make, model and class” isn’t the same. The value of one property may be comparable to 2 or more other properties.
Because of this, you may choose to do a delayed, or Starker Exchange.
This allows you to “not recognize” your proceeds from the the “sale” of an investment property immediately to give you time to find an exchange. A third party will retain these funds until the exchange is complete.
But there are some important rules to follow.
- The exchange must be identified within 45 days. The IRS needs to make sure that you’re not just selling your property and delaying taxation indefinitely.
- You can acquire a maximum of 3 properties in exchange that don’t exceed 200% of the fair market value of the relinquished property.
- The replacement properties must be clearly defined in the filing documents. You can’t leave ambiguity to keep your options open.
- You must complete the deal within 6 months.
- The exchange must be held for 2 years or it doesn’t qualify.
- The law also specifies that a property that is located in the U.S. can’t be exchanged for a property outside the U.S.
Like Kind Is Kind Of Broad
If you’re reading up on 1031, you’ll notice that language “like kind” is used, as in you can only make an exchange for property that is like kind.
At face value this might sound restrictive, but really it’s not. A like-kind property is any form of real estate exchanged for another form of real estate, including, for example:
- A condo exchanged for undeveloped land
- A commercial building exchanged for residential
- A farm exchanged for a 3 bedroom house in suburbs
As long as they’re both investment properties, they qualify.
Cash is Bad
First of all, it’s generally a good idea to get the right deal even if you have to pay capital gains. But in the case of an uneven exchange, you may end up with a little extra cash, called “boot”, and therefore a tax bill if the cash represents a capital gain.
Debt Reduction Is Income
If this is your first 1031 exchange, you should know of a common pitfall that first-time exchangers fall into. They don’t consider the debt on the properties.
If one or both properties have debt on them, this must be factored into the exchange.
If the exchange results in a reduction in your liability on an otherwise even exchange, you may still have a capital gain, so factor the amount that each party owes into your determination of whether it’s an even trade. This way there are no surprises when tax time rolls around.
A 1031 exchange is a great way to defer taxes, so that you can put your money to work for you now. But doing it right is important. If you’re unsure about an exchange, talk to a trusted accountant or expand your knowledges through online courses. And don’t pay capital gains that you don’t have to.