It’s really nice to make a massive profit when you sell real estate.
But it’s not so nice when you have to fork over a huge chunk of those profits over to the IRS come tax time.
That’s the reality of selling real estate, particularly as it applies to investment properties. More specifically, capital gains taxes usually have to be paid on any gains – or profits – of a real estate deal. If you sell an investment property for a profit, odds are you’ll have to pay capital gains taxes on it.
Or do you?
Luckily for real estate investors, there’s this little thing called a “1031 exchange” that allows investors to avoid having to pay capital gains taxes when they sell their properties.
But it’s not so cut and dry. There are certain requirements that investors have to meet in order to take advantage of such a tax perk.
Let’s dive into 1031 exchange rules to see what they’re all about and how they can help you save tens of thousands of dollars when it comes time to sell any one of your investment properties.
What Are 1031 Exchange Rules?
Section 1031 of the IRS tax code allows investors to defer paying any capital gains taxes on the proceeds of the sale of real estate if the profits are put towards the purchase of a “like-kind” property.
Basically, like-kind means similar and can include just about any other type of real estate. That means you could realistically exchange an office building for a single family home.
But you wouldn’t be able to use the proceeds of the sale of real estate to be put towards buying a car. They’re not “like-kind.”
As long as the purchase of another investment property is done within a certain period of time, a 1031 exchange can be put into effect.
What Qualifies as a 1031 Exchange?
In order for you to be able to take advantage of a 1031 exchange, the property being sold must be an investment property. The transaction is not meant for homeowners who are buying and selling their primary residences. Both properties must be investments.
That said, homeowners who are selling their primary residences may also be subject to capital gains taxes if they don’t meet certain criteria. They can avoid paying up to $250,000 for single owners or $500,000 for married owners who have filed their taxes jointly. Still, 1031 exchanges are not meant for primary residences and are only meant for investment properties.
Further, the property that is being purchased needs to be worth more than the one that’s being sold. If you end up paying less for the new property, you’ll be paying taxes on the difference.
Types of 1031 Exchanges
There are three different ways that a 1031 exchange can take place:
- Simultaneous exchange – This happens when a property is immediately exchanged for another.
- Deferred exchange – This involves selling a property first then buying another property in its place after a certain amount of time using an exchange facilitator.
- Reverse exchange – This occurs when the replacement property is bought first. with the help of an exchange titleholder. Then the current property is sold afterward.
It’s always important to use a qualified 1031 exchange facilitator for deferred or reverse 1031 exchanges. That’s because you’re not allowed to take possession of the proceeds of the sale before the exchange is complete.
There are even rules governing who can be an intermediary. For starters, you can’t use the same one that you used in the previous two years. You also can’t act as your own exchange facilitator.
Time is Ticking When it Comes to Finding a Replacement Property
In order to take advantage of 1031 exchanges, you can’t just take your time finding another property to purchase in its place. Instead, there is a certain amount of time that you have to find a like-kind property.
More specifically, you’ve got 45 days to identify a new property that you want to purchase. When you do, you’ll then have 180 days to complete the purchase.
A Maximum of Three 1031 Properties Can Be Identified
It’s pretty common for real estate investors to choose more than one piece of real estate that they have their eyes on. That’s because real estate deals typically take a long time to close, and any delays can creep up that would make them go past the 180-day mark.
By choosing more than one property, it’s more likely that at least one of the deals will go through. But only a maximum of three potential properties can be identified, as long as you close on one of them.
Further, any number of replacement properties can be identified as long as their combined market value doesn’t exceed 200% of the property being sold. For example, if you sell a property for $300,000, the combined market value of your next purchase can’t be more than $600,000.
How Are 1031 Exchanges Reported Come Tax Time?
You will have to pay the tax on the original profits of the sale of the property plus any additional gains since the purchase of the new property. A 1031 exchange is reported on IRS Form 8824 and submitted with your tax return for the year that the exchange took place.
Make sure you consult with a tax expert to ensure that all the rules are followed so the exchange doesn’t fall through.
For more information on 1031 exchanges, read more here.
1031 exchange rules are definitely complicated. That’s why it’s important to speak with an experienced tax associate to help you navigate all the ins and outs of 1031 exchanges.
These are handy tools that can help you save a ton of money. But you need to follow the rules closely in order to avoid getting dinged by the IRS.
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