As a real estate owner, you know the importance of making wise investments, so you get the most from your rental properties. However, as you get closer to retirement, you might hear about how a 1031 Exchange can help you get more out of your real estate assets, like rental properties, to work for you, especially if they have appreciated significantly in value.
However, there are a few things you need to know before you do a 1031 Exchange. Find out what a 1031 Exchange is, the different kinds, the benefits, and what kinds of properties qualify for a 1031 Exchange.
1031 Basics
Before you do a 1031 Exchange you need to know what a 1031 Exchange is and what types are available. A 1031 Exchange gets its name from section 1031 of the IRS tax code. This section of the tax code allows investors to defer capital gains on investment properties if the funds from the sale of the initial property are used to purchase another property (or properties) considered to be like-kind.
There are several kinds of like-kind exchanges that allow you to conduct a 1031 exchange including:
- Delayed Exchange
- Simultaneous Exchange
- Improvement Exchange
- Reverse Exchange
In order to comply with the tax code and complete a 1031 Exchange, you cannot directly receive funds from the sale of your current investment property. Instead, the IRS requires you to use a qualified third party often referred to as a “facilitator,” “accommodator,” or “qualified intermediary,” to hold the funds from the sale of the property and use them to purchase the replacement property you have identified. Adhering to the 1031 Exchange process allows you to avoid paying capital gains tax on the sale of your current investment rental property.
Why Do a 1031 Exchange?
A 1031 Exchange is a great investment tool for rental property owners who are looking to sell their existing property. As long as you are selling the rental property and replacing it with another investment property that is deemed to be like-kind, you can defer your capital gains tax on the sale of your current property and potentially put all of your equity towards the purchase of your new property.
A 1031 Exchange allows you to defer capital gains tax, and there is no limit on how long you can hold a new property without paying that tax. You can even purchase other properties down the road and still avoid capital gains tax, as long as you are doing another 1031 Exchange. If you wanted, you could even hold the property until you pass away and leave the property to your heirs without paying capital gains taxes.
For those nearing retirement, a 1031 Exchange can help you improve your rental property portfolio. For example, if you currently own a high-maintenance, low cash flow property, it may be time to sell and invest in a low-maintenance, high cash-flow property. This will make your life easier because not only will you have a more rental income each month, but also the costs of repair will be less, potentially resulting in greater net cash flow and fewer management hassles.
What Qualifies for a 1031 Exchange?
Another thing you’ll need to know before you do a 1031 Exchange, is whether or not your property qualifies and what kinds of properties are considered “like-kind.” It’s important to keep in mind that only investment properties (such as rental properties) qualify for a 1031 Exchange. Personal homes or primary residences don’t qualify. A 1031 Exchange also does not apply for properties you purchase with a near-term intent to resell, like house flipping. To qualify for a 1031 Exchange, most tax advisors will recommend that you hold your investment property for a minimum of two tax years.
However, for properties that do qualify, the IRS allows a fairly broad interpretation of what qualifies as being “like kind.” If you have a duplex, you don’t need to sell and repurchase another duplex. For example, a duplex could be exchanged for a single-family home, or an office building could be traded for an apartment complex. You could also exchange one property for several properties.
1031 Exchange Reinvestment Criteria
Another couple of rules you’ll need to know before you do a 1031 Exchange, is that 1) the property you purchase must be equal or greater in price to your current investment property, and 2) you must reinvest 100% of your net proceeds, If you are unable to satisfy both of these rules, you may still qualify to complete a partial 1031 Exchange which will allow a deferral of some of the taxes that may be otherwise owed.
Here are several other rules you need to know before you do a 1031 Exchange:
- No Cash “Boot”: You cannot receive “boot” from the sales of your property. A boot is any cash you might directly receive from a sale. If you receive boot, you will need to pay taxes on the amount you receive.
- 45-Day Window: You have 45 days from the date your rental property is sold to identify new properties to replace the property you are selling, or you cannot do a 1031 Exchange. This is one reason it’s important to work with an expert who can help the process go smoothly.
- 180-Day Window: You have 180 days from the date your property is sold to close on the purchase of your chosen replacement property. Again, an expert will help you with what you need to know before you do a 1031 Exchange.
While there are other considerations and rules, the above summary highlights the key points you need to know before you do a 1031 Exchange, so you can avoid paying capital gains tax on your rental property investment.
Consult with Experienced and Knowledgeable Specialists
In addition to understanding the basic 1031 Exchange Rules, you should seek the assistance of knowledgeable specialists who have significant experience in completing successful transactions. There can be added complexities in completing an exchange and this is an area where a “do it yourself” approach may not yield your desired outcome a party of your choosing, allowing you to defer capital gains on the equity of your rental property.
The First Guardian Team can help you learn everything you need to know before you do a 1031 Exchange and help you through the process. Keep more of your money working for you. If you’re approaching retirement, a 1031 Exchange might even help you sell off high-maintenance, low cash-flow properties and replace them with higher cash-flow investments. Contact the experts at First Guardian Group today to learn more and get help with your 1031 Exchange.
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