Real estate investing may be a lucrative endeavor, but capital gains taxes frequently cut into the potential earnings from the sale of real estate. However, US investors have the option to postpone these taxes by utilizing a 1031 exchange, a potent tax-deferral instrument. This provision, titled after Internal Revenue Code Section 1031, permits investors to exchange one property for another while deferring the tax payment.
Real estate investors may continue to grow their portfolios using this tax-saving technique. It’s critical to comprehend the operation of a 1031 exchange, its possible advantages, and some of the regulations and issues that surround its use.
How Does a 1031 Exchange Work?
The first thing to know in understanding this is knowing what is a 1031 exchange. Put simply, real estate investors can postpone paying capital gains taxes by using a 1031 exchange. However, they have to reinvest the money received from the sale to purchase another like-kind property.
The core idea here is “like-kind,” which implies that even while the attributes vary in kind or quality, they still need to be of a similar kind. For example, if both are meant for investment or business use, an investor can trade in a commercial building for a rental home.
If the new property has a value that is equivalent to or higher than the sold property, capital gains tax may be postponed. The investor may still be liable for certain taxes on any profit that is not reinvested, or “boot,” if it is received. On the other hand, if the exchange is executed properly, the entire transaction value can be applied to the purchase of the new property.
As stated by RealtyMogul, completing a 1031 exchange involves stringent deadlines. Investors have 180 days to close on a new acquisition after selling a property, and they have 45 days to find possible replacements. If these dates are missed, there may be no deferral advantage, and the entire transaction may be taxed as a sale.
The rules were not always this strict for 1031 exchanges. Traditionally, the capital gained by selling a property could have been used for investing in other assets, such as:
- Business machinery
- Collectibles
- Artwork or patents
However, it was all changed with the introduction of the Tax Cuts and Jobs Act. This act made it mandatory for the gained capital to be invested only in other like-kind real estate properties.
Key Benefits of a 1031 Exchange
The opportunity to postpone capital gains taxes is the main benefit of a 1031 exchange, but there are additional advantages as well. This approach may help investors diversify into a wider range of real estate assets and boost cash flow. Here are several ways that real estate investors stand to gain from this exchange:
Tax Deferral
The basic idea behind a 1031 exchange is to postpone paying capital gains taxes, which may be high, particularly for long-term real estate holdings. Tens or even hundreds of thousands of dollars can be saved in taxes through deferral, depending on the value of the property being sold. Because of this tax-saving option, investors may reinvest more of their cash and expand their portfolios more rapidly and profitably.
In addition to delaying the capital gain tax, it can also postpone the additional 3.8% income tax on net investment. According to USA Today, this additional income tax applies to people with high net worth, which they can avoid with 1031 exchanges. It also helps eliminate the need for a 25% depreciation recapture tax for investors.
Portfolio Diversification
Due to the “like-kind” character of 1031 exchanges, investors have a great lot of freedom in how their arrangements are structured. Within the real estate industry, there is ample room for diversification, even if the transaction must involve buildings with comparable uses.
To diversify their real estate holdings, an investor may, for instance, sell a modest multifamily rental property. They can then swap it for a retail establishment or a commercial office building. This can help diversify investments throughout a variety of asset types, which can help lower risk.
Opportunity for Upgrading to Higher-Value Properties
The most popular tactic used with a 1031 exchange is “trading up” to properties with higher values. An investor can move into a more desirable property with more potential for cash flow by delaying taxes.
Wealth and income can increase using this method without incurring an instant tax penalty. This might eventually lead to a portfolio of properties that yields substantially more income than what would have happened without using the 1031 provision.
Estate Planning Benefits
When it comes to estate planning, the 1031 exchange may also be advantageous. If an investor passes away, their heirs may get the property on a stepped-up tax basis. This means that the property’s worth at the time of death will now be used to determine capital gains.
There may be no deferred capital gains taxes if the investor kept the property until their death. This can be a useful strategy for protecting family wealth and saving a large amount of taxes for future generations.
Important Rules and Considerations
Although the like-kind criterion allows for some flexibility, it’s significant to remember that properties must be retained for business or investment purposes. This implies that unless properties fulfill certain requirements for rental usage, personal residences or vacation houses usually do not qualify. For properties to be eligible, they must have a business or investment purpose.
Investors must follow certain timelines when it comes to the 1031 exchange. The tax deferral may be in jeopardy if the 45-day identification period is missed; it starts as soon as the original property is sold.
In addition, there is minimal margin for error or delay given the strict 180-day deadline for finishing the new acquisition. Making use of skilled intermediaries and other seasoned specialists may assist in guaranteeing a seamless transaction.
Another important rule is that a seller and a buyer cannot perform a 1031 exchange immediately. Rather, the transaction has to be handled by a competent intermediary who will retain the selling money until the replacement property is bought.
By using a middleman, the investor is prevented from seizing custody of the money, which might render the transaction void. Selecting a trustworthy and informed intermediary is important for preventing any tax or legal blunders.
Having a qualified intermediary (QI) is important to ensure secure transactions and that they do not become void. However, it also means additional cost to you, as you might have to hire someone for the purpose. Depending on the transaction, the qualified intermediary may charge between $610 and $1,200.
Frequently Asked Questions
How long can money stay in a 1031 exchange?
Regarding the holding time for a 1031 exchange property, there are no set regulations. Nonetheless, decisions issued by the IRS suggest that a two-year holding time is deemed adequate to satisfy the qualified use test. You have two options: sell the property after two years to get the income or reinvest the proceeds in another property. Alternatively, you can hold the property for as long as you want to.
Can I invest in a REIT with a 1031 exchange?
A straight 1031 exchange into a REIT is not permitted by the IRS since REIT shares are not regarded as “like-kind” property. Although REIT is a way of investing in real estate, it is not valid to make a direct investment in it.
How fast can you do a 1031 exchange?
The Exchangor has 45 days, counting from the closing date of the surrendered property, to suggest (identify) possible replacement properties. There are then 135 more days left to buy the replacement property and finish the deal. As a result, it takes 180 days to execute the whole 1031 exchange.
A 1031 exchange is a more versatile instrument than merely a tax deferral. It may be used as a long-term investing strategy to promote asset preservation, portfolio diversity, and growth. When carried out correctly, it can allow real estate investors more chances to increase their holdings without having to worry about capital gains taxes.
