Taxes aren’t exactly the most enticing of topics, unless of course you are an accountant. However, when it comes to real estate investors confronted with the potential of capital gain taxes, there is one topic that is extremely exciting - 1031 Exchanges!
The old adage says that there are two things you can’t avoid - death and paying taxes. What if you could defer them though? 1031 Exchanges do just that, allowing real estate investors to defer their capital gain taxes. In this article we'll highlight some of the key 1031 Exchange rules.
A 1031 Exchange, also known as a Section 1031 Exchange or a Like-Kind Exchange, is a portion of the US tax code that enables real estate investors to defer or postpone paying capital gain taxes following the sale of a business or investment property provided the proceeds are reinvested in a similar property under a like-kind exchange. These gains deferred under IRC Section 1031 are tax-deferred, and not to be confused with being tax-free.
If you are not a veteran real estate investor, you are probably asking yourself, what actually qualifies for a Like-Kind Exchange?
First and foremost, both the property you are selling and the property you are exchanging for both need to be used for business or investment purposes. Primary residences and vacation homes do not qualify under this definition.
Second, like-kind property is such that both properties are similar. The IRS defines like-kind as “property of the same nature, character or class.” The rules are fairly vague and should be evaluated on a case-by-case basis to ensure compliance. One of the standout exceptions under section 1031 of the Internal Revenue code is that properties located in the United States are not considered like-kind to properties located outside of the United States, so keep it domestic!
Just as there are clear rules on what types of property qualify for a Like-Kind Exchange, the IRS is as explicit with what property is excluded under IRC Section 1031. These exclusions include the following:
There are two time limits that you, your tax, legal, or accounting professionals, as well as the qualified exchange intermediary or facilitator need to be aware of when considering deferred exchanges:
In order to adhere to a deferred exchange being an integrated transaction, investors use a qualified intermediary or exchange facilitator to ensure compliance. These intermediaries should be contacted and engaged prior to considering or executing any part of an exchange transaction.
Upon sale of the relinquished property, the proceeds of the sale are held by the qualified intermediary, not you. Following your notification of potential replacement properties to your intermediary, and after selecting the replacement property or properties, the funds held by your qualified intermediary are then used to acquire the replacement property and complete the exchange within the statutory time limits.
It is not uncommon for home owners to ask - do these exchange rules apply if I sell my primary residence and want to buy a different personal residence? The answer is no. While at first it may seem like you are missing out compared to investment property owners, it is important to remember that the federal tax code has separate provisions and exclusions for capital gain taxes on primary residences. According to the IRS on home sales, “If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse” The one timing exception on this is that you need to use the property as your primary residence for a minimum period totaling 2 years out of the last 5 years prior to the sale of the property.
The ability to defer taxes on your gains allows those potential future gains to compound without having to pay Uncle Sam til later down the road. The best analogy for the novice real estate investor is that of retirement accounts like IRA’s and 401k’s where your savings are allowed to grow without taxation until you retire and begin pulling money.
As we’ve discussed above,1031 exchanges are far more complex than retirement savings, however the goal of letting your investments grow as tax efficiently as possible is something all investors can be happy as the put themselves on a path of greater wealth potential.
DISCLAIMER: This material was provided for informational purposes only, and is neither intended to provide, nor should be relied upon as tax, legal, or accounting advice. Prevu and its subsidiaries do not provide tax, legal, or accounting advice. You are encouraged to consult your personal tax, legal, or accounting professionals before considering any transaction as your individual situation may vary.
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