Everything you need to know about a 1031 Exchange
When it comes to real estate, a key factor to successful investing can be minimizing your tax burden. With a 1031 exchange, you might be able to build your real estate portfolio while deferring your taxes until later. Here’s how.
What is a 1031 exchange?
A 1031 exchange effectively allows you to swap one real estate property with another, similar property and defer capital gains taxes until later. This can help you avoid the taxes you would otherwise pay on the sale of an investment property today.
How does it work?
In its most basic form, you can conduct a 1031 exchange like this:
Identify a property you want to purchase.
Sell a property you currently own to finance the purchase of the new property.
File the appropriate paperwork with the IRS for a 1031 exchange.
Let’s go through an example of how this might look. Imagine you are a real estate investor and you are about to sell a property at a profit. But instead of taking the proceeds from the sale, you want to roll that money over to purchase a new property. By purchasing another property and utilizing a 1031 exchange, you will not pay any taxes today for the sale of the first property, and only pay taxes later when the newly owned property is sold.
You will need to tell the IRS about the property you are selling (known as the relinquished property) and the property you are purchasing in exchange (known as the replacement property).
Keep in mind that the properties must be considered like-kind by the IRS, meaning, the new property has the same, or higher value than the property you sold.
Are there restrictions?
Not all real estate transactions will qualify for a 1031 exchange. To consider using this financial strategy, the following qualifications must be met:
The sold property must be an investment property, not a primary residence.
The in-kind property must be identified to the IRS within 45 days of the sale of the first property.
You must close on the new property within 180 days of the sale of the first property.
You cannot receive proceeds from the sale to a personal account. Instead, all funds must be kept in an escrow account.
You will need a qualified intermediary to facilitate the exchange on your behalf.
If you follow these directions, your real estate transaction may qualify for a 1031 exchange.
Benefits
Can be used to avoid a large tax bill today.
Allows you to purchase a new property with a higher potential return on investment.
You can consolidate multiple real estate properties into one larger property.
Drawbacks
There are strict restrictions and regulations to qualify.
You must identify and purchase a new property quickly.
You’ll eventually pay taxes later at the sale of your replacement property.
Another way to help with real estate investing
A 1031 exchange is a helpful tool for real estate investors who don’t want to incur a major tax bill today. By making an in-kind exchange, you can defer taxes while still purchasing a new investment property. However, 1031 exchanges can be very complex and intricate from a tax standpoint, so it can help to talk with a financial or tax professional to ensure you have all of your bases covered before conducting this type of transaction.
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