The 1031 Exchange – Real Estate Investing and Capital Gains Tax
Profits from selling real estate investments are typically subject to a capital gains tax, which is defined as a tax levied on profits from the sale of property or an investment. Depending on the amount of profit, individual homeowners can sometimes be exempt and avoid paying this tax. For real estate investors, the profits are normally too large to be exempt and the tax rates can be pretty steep, anywhere from 5% or 15%, depending upon your income level plus your state taxes. That means if the sale of an investment property yields a profit of 500,000 dollars, the capital gains taxes could be anywhere from 25,000 to 75,000 dollars. That’s a large chunk of your profit going straight to the IRS. However, this shouldn’t cause you to shy away from real estate investing. There is still money to be made and a 1031 exchange can help you defer the capital gains tax. Many real estate investors, new and experienced, are unaware of the 1031 exchange and how to benefit from it.
When Does a 1031 Exchange Apply?
It is possible to avoid capital gains tax on profits from real estate investing. If those profits are reinvested into another piece of real estate, a 1031 exchange may apply. According to the IRS “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Wondering exactly what qualifies as “a property held for productive purpose in business or as an Investment”?
Both properties must either:
- Actively used in a business or trade
- Income-generating, such as a rental property
- Expected to increase in value, such as vacant land to be sold later for a profit
Primary and secondary residences do not qualify for a 1031 exchange, but under certain circumstances, a vacation property may.
For at least two years prior to or after the exchange:
- The property must be rented to a non-relative for at least two weeks
- The property can be rented to a relative as a primary residence at a fair market price
- The property may only be used personally for two weeks or 10% of the rental time
- The investor can maintain the property indefinitely and maintenance must be documented.
- Income from the property must be reported on Schedule E of the investor’s tax return.
As for like-kind, it does not mean that the new property has to be exactly the same as the original one. It should be similar but does not have to be of the same quality. All profits simply have to be used for another investment property, whose purchase price is equal to or greater than that of the property sold.
So what does this mean in regards to real estate investing? By reinvesting profits into another investment property, the transaction is viewed as an exchange rather than a sale and purchase. Because the profits are locked up in the new property and not actual income received by the investor, there is nothing to be taxed.
The 1031 exchange does not apply to those who purchase real estate as inventory solely for resale or house flipping.
A Qualified Intermediary is Necessary
The execution of a 1031 exchange must be handled by a qualified intermediary. The investor can not act as their own facilitator, nor can their agent, broker or anyone they have worked with during the past two years prior to the exchange. They need to be an independent party whose sole purpose is to facilitate the exchange process.
Once closing is complete on the original property, the title company will send the profits to the intermediary to hold until it is time to close on the new property. At that time, the intermediary will disperse the funds to the appropriate parties to complete the exchange and delivery of the property to the investor. This allows the investor to avoid having constructive receipt of the funds.
Meeting Required Deadlines
While the exchange of properties doesn’t have to be simultaneous, there are a couple of time limits that must be strictly adhered to in order to qualify for a 1031 exchange. The first is a 45 day period known as the Identification period. Within this time frame, the investor must identify potential replacement properties in writing, including street addresses, intended to be purchased and submitted to the intermediary.
The second time frame is known as the Exchange period which is 180 days from the sale of the original property. The investor must acquire the replacement property during this time. Both deadlines must be met to successfully complete a 1031 exchange.
Tax-Deferred vs Tax-Free
It is important to keep in mind that a 1031 exchange is tax-deferred, not tax-free. The exchange postpones the tax and improves your current cash flow. When you eventually sell the new property, you will have to pay capital gains tax.
However, there is no limit on how long you can own the property and you can also do another 1031 exchange with the new property. Provided you follow all the guidelines, you can continue to defer the taxes. You can even leave as an inheritance. The cost basis of the last property would be adjusted to the current value and your heirs would not be responsible for any accumulated capital gains taxes.
Considering Real Estate Investing? Partner with Professionals
As with any real estate transaction, it’s vital that you work with experienced professionals when investing in real estate. The Freeman Group has the knowledge and expertise to handle any type of investment, whether it’s a single income property or an entire development project.
We’re certain our team can provide you with a variety of investment opportunities and help you make the best choice for achieving your specific goals. So, if you’re ready to take the leap and add real estate to your portfolio, let’s talk.