Please note: I am not a Tax Attorney nor a CPA and this should not be considered legal advice. Please consult your qualified Tax Attorney or CPA first before considering a 1031 exchanged.
Selling a property isn’t always a walk in the park, let alone buying a new one, but it can become even more challenging when factoring paying capital gains taxes. That is where a 1031 exchange comes in. A 1031 exchange or an IRS tax deferred exchange, is a way to avoid or defer capital gains taxes while you sell one investment property, trade it for another, and keep the money invested. This blog post will provide you with a comprehensive guide detailing what a 1031 exchange is, its benefits, and the process of executing it.
First, let’s understand what a 1031 exchange is. Simply put, it’s a tax code that enables you to exchange one property for another while avoiding taxes. So, suppose you sell an investment property and buy another within the specified time frame, you will not pay capital gain tax at that time. Instead, the tax gets deferred until you sell the newly bought property. Moreover, if you continually exchange properties and defer taxes until death, your heirs will inherit your properties, and the deferred taxes could wipe out, that’s because of the step-up of basis at death rule.
Next, let’s talk about the benefits of a 1031 exchange. Firstly, you get to defer paying a hefty capital gains tax. For instance, if you buy a property at $200,000 and sell it years later for $500,000, you may have to pay a hefty federal and state capital gains tax. However, if you used the 1031 exchange, you could defer this tax and invest the entire $500,000 into another property. This money can be used to increase your equity, which can lead to higher profits over time. Secondly, the exchange enables you to simplify your investments. If you have invested in several properties with different values, the exchange enables you to trade them for a single investment property that is worth more and easier to manage.
Thirdly, let’s look at the process of executing a 1031 exchange. First you will list your current investment property for sale. Once you find a buyer you may need to let them know you’re participating in a 1031 tax deferred exchange. You will also want to hire a 1031 exchange company that understands the rules and regulations that come with it. They can advise you on the best way to go about it, ensuring you do not violate any codes or miss any deadlines. Next you will want to start identifying possible replacement properties. Once you sell the first (relinquished) property, you have up to 45 days to identity possibly replacement properties and up to 180 days to close on that replacement property. All funds from the relinquished property sale gets held by the 1031 intermediary company, you never touch the money, they will process it with the title company for the next replacement property sale.
In Summary: Once you find a buyer for your property and get it under contract, you’ll need to contact a 1031 exchange intermediary company to ensure that all IRS guidelines are followed. This company will hold the proceeds of the sale of your relinquished property, and you won’t receive any money from the sale. Instead, the intermediary will hold on to the proceeds until you’re ready to purchase your next property. Within 45 days of selling your property, you’ll have to provide the intermediary with a list of three potential replacement properties. With the help of the intermediary, you can defer your taxes on the sale of your property and reinvest in a new one.
In conclusion, a 1031 exchange provides an excellent option for investors looking to sell one property and buy another while deferring capital gains taxes. It allows you to keep your money invested while avoiding a substantial tax burden that would otherwise limit your returns over time. If you’re considering a 1031 exchange, it’s advisable to work with a reputable 1031 exchange company that can guide you through the complexities of the process, from start to finish.