1031 Exchange
If you are looking to build wealth, a 1031 exchange is a savvy tax tool that can ensure that you maximize profits and defer costly capital gains taxes.
This is a legitimate tax shelter (a type of deduction) that protects you from capital gains taxes on the sale of investment properties.
They are so popular that slang has sprung up around them. It’s standard for people to say things such as, “1031 that property for a new one.”
Why defer taxes?
The capital gains tax is incurred whenever you sell an investment property for more than you bought.
In addition to this tax, you also pay depreciation recapture taxes, which can double or triple (or more!) your tax balance.
What is a 1031 exchange?
It is a method of selling a business property and buying a new one. This method lets you defer capital gains taxes until you sell the building for cash.
You won’t pay taxes on the capital gains on the transaction until you sell the property.
The purpose of this deduction is so that investors can raise cash quickly to buy another property.
This means you can buy property A, then sell it a few years later and buy property B. With 1031, you won’t have to pay capital gains taxes on property A until you sell property B.
It is called a 1031 exchange because of the loophole in Section 1031 of the Internal Revenue Code (IRC).
Which properties qualify?
Most real estate qualifies as long as it is like-kind, and the definition of like-kind property is surprisingly flexible.
Properties are like-kind as long as they are held for use in a business, trade, or investment, such as an apartment building.
This means you swap what we may typically think are different properties but are considered like-kind. For example, you are trading a warehouse for an office building.
It is possible to do an exchange with residential properties, but the process needs proof of tenancy by a renter for specific lengths of time.
You can also attempt an exchange for ownership in a Delaware Statutory Trust (DST). DSTs are popular entities for real estate investors to hold assets or properties.
Which properties don’t qualify?
Many types of investment property don’t qualify, and several real estate properties don’t qualify as like-kind properties. Below is a list, though it is not comprehensive.
- Primary Residences
- Vacations homes
- Out-of-State Properties
- Securities
- Inventory
- Stocks
- Partnership Interests
- Bonds
- Stock in trade
- Debt
- Partnership interests
Are there workarounds for residences?
The simple answer is yes.
You can rent out your primary residence or vacation home for a specific time, then complete an exchange. You must provide proof of tenancy by another person.
How does a like-kind property exchange work?
You begin by selling your property. Then, you hand over your proceeds to be escrowed by a qualified intermediary until you buy another property. The qualified intermediary uses the funds from selling your first property to buy the second property.
You have only about six months (180 days) to complete your exchange. This time frame starts the day you close on the property and ends the day you buy another property.
Reverse exchanges
Here is a brilliant hack: a reverse exchange! This involves buying a property first and then selling one. It can be useful if you see a property you want but aren’t sure which of your existing properties would be the best to sell.
What is a qualified intermediary?
A qualified intermediary is a company that practices 1031s.
It is essential to choose a qualified intermediary with care.
There is little regulation within this industry, so it is essential to ensure your provider has the necessary knowledge of tax code, finance, and experience. Do your due diligence and choose a service provider who is honest, transparent, and well-respected in your community.
If your qualified intermediary makes a mistake, then you could be liable for the taxes incurred on your transaction.
Stacking exchanges
The brilliant thing about a 1031 exchange is that you can stack them and potentially never pay the taxes incurred.
For example, let’s say you sell property A, using a like-kind exchange to buy property B. Then you can sell property B and buy property C, again using a like-kind exchange. You sold two properties, bought two properties, and never paid a capital gains tax.
Conclusion
Like-kind property exchanges are the perfect accounting tool for legally maximizing your profits when selling an investment property.
It is also an excellent tool for small businesses or real estate investors to maximize cash flow without much effort.
Taxes can be expensive, or you can work with a qualified accountant to establish a plan for maximum profits and minimum tax balances using deductions like this.
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