1031 Exchange
If you are looking to build wealth, a 1031 exchange is a savvy tax tool to use to ensure that you maximize profits and defer costly capital gains taxes.
This is a legitimate tax shelter (a type of deduction) to protect you from capital gains taxes from the sale of investment properties.
They are so popular that slang has sprung up around them. It’s fairly common 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 it for.
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 a few years later sell property A and buy property B. WIth a 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 this loophole in the Internal Revenue Code (IRC) in Section 1031.
Which properties qualify?
Most real estate qualifies as long as it is like-kind – and the like kind property definition is surprisingly flexible.
Properties are like-kind as long as they are being held for use in a business, trade, or investment use, such as an apartment building.
This means you swap what we may typically think are different properties, but are actually considered like-kind. For example, 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 certain lengths of time.
You can also attempt an exchange for ownership in a Delaware Statutory Trust (DSTs). 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 types of 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 certain 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 the sale of your first property to buy the second property.
You have only about 6 months (180 days) to complete your exchange. This time frame starts the day you close on the property. It ends on the day you buy another property.
Reverse exchanges
Here is a brilliant hack: a reverse exchange! This when you buy a property first, then sell one. This can be useful if you see a property you want, but you aren’t sure which you already own property would be the best to sell.
What is a qualified intermediary?
A qualified intermediary is a company that practices 1031s.
It is important to choose a qualified intermediary with care.
There is little regulation within this industry so it is important to make sure your provider has the needed education in tax code, finance, and experience. Do your due diligence and choose a service provider that 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 2 properties, bought 2 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 a great tool for small businesses or real estate investors to maximize cash flow without a ton of 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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