The 1031 exchange is a loophole for property owners or real estate investors to avoid paying capital gains when selling their property. It's a complicated maneuver to pull off, but essentially involves purchasing a new property that's close to the same value of the property being sold. It's not available for primary residences but can be used for vacation or secondary homes. See how it works and which sales benefit most from the 1031 exchange.
How It Works
This rule is defined by the tax code as the purchase of a new piece of real estate property that is similar in value to the real estate property being sold. Under this rule, a person will not have to pay capital gains which means they have an opportunity to all but eliminate the taxes associated with the sale. (Capital gains can total up to 20%, depending on the owner's personal income.)
For example, if a property achieves capital gains of $200,000 upon sale, the owner could be taxed by up to $40,000. However, if the owner chooses to purchase another property that costs as much as the one they just sold, they aren't subject to capital gains. The IRS wants to see that there is no net loss of money on the transaction in order for it to qualify.
A 1031 tax free exchange doesn't allow an owner to avoid taxes forever. These taxes are simply deferred until the owner finally does decide to sell the property without purchasing another one. There are no limits placed on how many times a person can complete a 1031 exchange, so serial investors don't have to worry about exhausting their privileges if they make several transactions a year.
The only possibility an investor may have to pay taxes for their 1031 exchange is if they're subject to a depreciation recapture gain. Under this clause, the IRS may calculate the total depreciation and then tax it as income. This tax is a relatively abnormal one, but an investor should be aware of the possibility before making the sale.
Knowing the Risks
There are a few things to keep in mind before doing a 1031:
- Find help: Because the tax rules are new this year, few investors would attempt this exchange without professional help (at least the first time around).
- Properties are flexible: Property owners aren't required to purchase the same type of property they owned before. So if they sell a vacation home, they can use the money to purchase an apartment complex if they wish.
The rules of the tax code are loose enough that there are challenges that can be made to a 1031. For example, some officials may try to stop an exchange for certain properties. It's another reason why it helps to have a financial advisor to consult with during this time.
There is a way for investors to delay the exchange if they can't find a property that sparks their interest at the time of the sale. In this case, a Qualified Intermediary (e.g, CPA, lawyer, real estate lawyer, etc.) will keep funds in escrow until the purchase and the sale are completed. As soon as the property is sold, the seller has up to 45 days to name the property they plan to buy. In fact, a seller can specify up to three properties if they're still having trouble deciding. However, they are required to purchase at least one of the properties if they choose this option. The seller has 180 days from the date of sale to complete the purchase of a new property.
The idea behind a 1031 exchange is that the values will be extremely similar. However, most sales won't match exactly based on everything from closing costs to negotiated value. If there is any additional money left, the intermediary will release the funds back to the seller. However, this income is usually required to be reported to the IRS as a capital gain.
San Pedro home sellers may also be taxed for decreased liability of their new property. This is considered a financial gain and will be treated as such. This means that sellers may still be taxed even if the values of the property are closely aligned.
For serial investors and second-home owners, a 1031 exchange provides a tremendous opportunity to invest more money in real estate and less in capital gains. However, the complicated rules of a 1031 make it easy to make a mistake. Owners should strongly consider talking to a real estate expert to avoid any unnecessary scrutiny or questions from the IRS.