If you are thinking about selling an investment property, non-owner occupied property or vacant land, you should consider structuring the transaction as a 1031 Tax Deferred Exchange.
What is a 1031 Exchange?
Think of a 1031 exchange in the same way you think about rolling over your 401k money to an IRA. If you do it in a certain way, you don’t need to pay taxes. The same is true for investment real estate.
Congress passed Section 1031 of the Internal Revenue Code in 1921. Its purpose was to avoid taxation of ongoing investments in property and to encourage active reinvestment. This helps real estate investors grow their portfolios and increase net worth faster and more efficiently than would otherwise be possible.
So basically, if you own or manage investment or business property, you can implement a 1031 exchange. You benefit by deferring payment of capital gains taxes on the investment properties until you sell. This increases your buying power because funds you would pay to the IRS can instead be reinvested in replacement property. It is also sometimes referred to as a “like-kind” exchange.
How to Use a 1031 Exchange
Unlike the IRA rollover example where it’s relatively easy to secure the tax break, the 1031 exchange has some stipulations. And unfortunately, most people learn about this strategy after something has been done that disallows its use.
For example, once the sale is final on the property you’re selling, it’s too late to enact a 1031 exchange. Additionally, there are also other regulations to follow. You need to hire a 1031 exchange intermediary who will hold the proceeds of the sale in escrow. Then, the intermediary will use the proceeds to purchase the new property. It’s important to note that at no time are you able to have possession of the money.
What are the rules?
Because of these regulations, you need to follow the rules to be successful.
If you own or manage investment or business property, you can exchange it with a like-kind property to defer capital gains tax. Just remember, you need to understand the rules before doing one on any property you manage or own.
- Needs to be like-kind property
- Must be the same taxpayer
- Needs to be investment or business property
- Property must be of equal or greater value (in some cases you can purchase multiple properties to adhere to this rule).
- Must follow the 1031 exchange timeline, which is why you need to plan well in advance of selling your property.
It’s also important that you seek the help of experts so you don’t violate any of the rules and end up owing a lot of money in taxes and penalties.
It’s likely you’ll be working with a real estate agent and a lawyer for the sale, but you’ll also need to hire a 1031 exchange expert. There are companies out there who can provide experts to help with the process.
In summary, the 1031 exchange can be a useful tax tool that helps minimize liability. And just being aware it’s a potential option is important if you’re ever considering this type of real estate transaction. And if so, contact us so we can introduce you to experts that can help you determine if it would work for your personal situation.
Listen to our podcast episode for a live discussion on 1031 exchange.