One of the tools that real estate investors have at their disposal is the 1031 exchange. This is a type of “like-kind” exchange that allows real estate investors to defer the capital gains taxes they pay when they sell a property. Essentially, it allows them to put off paying taxes so that they have more capital available to complete the purchase of a different (hopefully more lucrative) property.
This is a big deal because, by the time you pay federal and state capital gains taxes, you can end up paying as much as between 15% and 30% of your earnings. That can really hamper your ability to move on to the next great opportunity. This is where a 1031 exchange can help.
What is the 1031 Exchange Rule?
The 1031 exchange rule is set up to ensure that you are accomplishing a “like-kind” exchange with your investment property. This means that you need to do more than just sell a property and buy another. There are specific qualifications that your properties need to meet, and there is a procedure the IRS expects you to follow. Some of the requirements of a 1031 exchange include:
- Both properties (the old and the new) must be held for investment purposes, or they need to be used in a business. So, you can exchange an office building for raw land, or exchange a single family rental home for a multi-family property. There are other acceptable exchanges as well. The important thing to remember is that you can’t involve residential property or sell your real estate and try to do a 1031 exchange for other asset classes, like notes or stocks.
- You have 45 days from the close of the original property to identify the new property you want to purchase. You have 180 days from the time your sold property is transferred to the buy in order to complete the transaction on the new property.
- You can’t access the proceeds from the first transaction. This means that you can’t use the money gained from your sale. If you could use the money, it wouldn’t exactly be an exchange. The IRS would come in and expect you to pay capital gains taxes on your earnings. Instead, the transaction is handled by a qualified third party. All of the funds remain with that third party, and are used to complete the exchange once you have determined on a replacement property. As you might imagine, the 1031 exchange is not a DIY investing project.
You should also be aware of the impact of “boot.” This is something extra received during the course of the exchange. This might be a different property, cash, or some other investment or liability. Any boot that is added to your exchange transaction is subject to taxes.
A 1031 exchange isn’t designed for you to sell an investment property and then pocket the cash or invest the cash in a different asset class. Instead, it’s meant as a tool to help real estate investors find a new opportunity, and to accomplish the new investment without the capital drain that comes from paying taxes on their gains. If you want to replace one investment property with another, the 1031 exchange can help you accomplish this without too much trouble.