Save On Capital Gains Taxes With A 1031 Exchange

A 1031 exchange can allow you to exchange one piece of investment real estate for another, deferring capital gains taxes on any profits you may make from the sale of the first investment property. You can do one 1031 exchange after another, pushing your capital gains tax bill further and further into the future. Here’s what you need to know.

1031 Exchanges Must Be Like-Kind

Section 1031 of the Internal Revenue Code specifies that no gain or loss shall be recognised on the exchange of one piece of investment real estate for another, as long as they are of like kind. That doesn’t mean that you have to trade your apartment building for another – it just means that you have to trade it for another investment property

You Need An Intermediary

In order to perform a 1031 exchange, you need to find a qualified intermediary. The qualified intermediary will hold the proceeds from the sale of the first property on your behalf, and use it to buy the property you’re swapping for. Because the intermediary handles your money, you can’t be said to have received any proceeds on the sale of your initial property. 

There Are Some Important Deadlines

Sometimes, you can perform a 1031 exchange if you happen to find someone with a property you want who wants your property. In that case, the sale of your old property and the purchase of your new one can take place at the same time. But you’ll usually need some time after the sale of your initial property to find another property to invest in. In that case, you can do what’s called a delayed 1031 exchange, and buy your replacement property some weeks or months after you’ve sold your initial property. You can even do what’s called a reverse 1031 exchange, in which you buy the replacement property first and then sell your original property. 

If you’re doing a delayed 1031 exchange – which is the most common type – you’ll have 45 days from the sale of your initial property to designate some properties you’re interested in buying. You should designate the replacement properties in writing to your intermediary. Once you’ve designed your three properties, you‘ll have 180 days to close on a replacement property.

You Can Do As Many 1031 Exchanges As You Want

As long as you do your 1031 exchanges correctly, you can do as many of them as you want. You can roll the capital gain on your initial property over into a new property, and then sell that property and roll those capital gains into a new property, over and over for as long as you want. Eventually, if you do sell a property outright, you’ll have to pay long-term capital gains taxes, but you can defer paying capital gains tax for years and have that much more capital for your property investments.

1031 Exchanges Can Help With Estate Planning

You can only use 1031 exchanges to defer capital gains, not to avoid them – with one exception. If you die without ever selling your replacement property, your heirs will inherit it at its current market value, and they won’t have to pay capital gains taxes on the appreciation in the value of the property. 

You Can Only Exchange Investment Properties

Prior to 2004, when the tax code was changed, you could use 1031 exchanges to swap one holiday home for another, and even turn that home into a primary residence while still delaying the recognition of any capital gains on the property. You can’t do that anymore – now you can only buy a holiday home through a 1031 exchange if you’re renting it out for income. If you want to swap your current holiday home for another property using a 1031 exchange, you’re going to have to rent it out for six months or a year to convert it into a rental property. 

Conversely, if you want to move into a property you bought in a 1031 exchange, you need to wait at least two years, during which you rent the dwelling at market rate for at least 14 days each year, and during which your personal use of the property can’t 10% of the number of days each year that the property is rented, or 14 days, whichever number is greater.

1031 exchanges can be a great way to save on capital gains taxes, especially if you want to pass the investment property down to your heirs. With a little advance planning, you can use 1031 exchanges to significantly increase your real estate holdings and personal wealth.

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