Investing in property is one of the most lucrative endeavors you can delve into if you do it right. Tax rules abound for investors when it comes to selling off property, but there is a popular tool to help maximize profits and avoid capital gains tax. A 1031 exchange can do just that is one of the best bets for building foundational real estate wealth.
What is a 1031 exchange?
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows an investor to avoid paying capital gains taxes on the sale of an investment property, as long the proceeds are reinvested within certain time limits in a property or properties of equal or greater value. In short, it’s a tax-deferring transaction that can be used in just about any property portfolio.
What are the rules that apply to a 1031 exchange?
- It is a swap of properties that are held for business or investment purposes. (Houses that are flipped do not qualify.)
- The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred.
- If used correctly, there is no limit on how many times or how frequently an investor can execute a 1031 exchange.
- The rules can apply to a former primary residence under very specific conditions.
What is the timeline for the original property versus the replacement property?
The current rules say an owner has 45 days from the sale of the original property to identify the replacement property. The seller is also required to close on the new property within 180 days of closing on the first one.
Investors are warned to watch that timeline closely; indeed, most experts recommend that the replacement property be identified prior to selling, especially in a competitive, seller’s market like the one that is currently under way.
What are the requirements to qualify for the tax break?
- The property purchased must be of equal or greater value.
- You must exchange one rental for another rental. An investor cannot use the 1031 exchange to sell a rental home and in turn buy a piece of land that isn’t attached to income. On the flip side you cannot sell a rental home and use the exchange to buy a vacation home
- The qualified intermediary, who holds the escrow exchange fund, plays an important role in this process. If an investor touches any of the money made when she sold a property, she will immediately be subject to paying taxes. Spending the money or moving it into an investor’s account would incur penalties; such actions void the 1031 exchange.