Real estate investment is lucrative. Consistent cash flow from properties offers financial security. The value of this tangible asset is also strong and less likely to plunge. However, capital gains taxes on real estate investment can weaken your profits.
You’re not completely out of luck, as there is a way to minimize tax liabilities on investment properties while maximizing profits. That, if you haven’t already guessed it, is a 1031 exchange.
Named after Section 1031 of the U.S. IRC (Internal Revenue Code), it permits investors to sell investment or business properties without triggering taxes, given that they reinvest in a like-kind property.
A 1031 exchange isn’t simply a tax-deferral mechanism. Instead, it’s a smart strategy that can help investors boost their investment power and portfolio value.
This article discusses the basics of the 1031 exchange and the steps to mastering it. Hence, read it until the end!
Understanding the 1031 Exchange
At its core, a 1031 exchange is a tax-deferred transaction that occurs when a real estate owner sells one investment property to purchase another.
Swapping one property for another typically requires property owners to pay a hefty amount of capital gains taxes. Nonetheless, you can defer these taxes indefinitely if the exchange qualifies as a 1031 exchange. This provides investors with the opportunity to shift their focus into a new area or move into a different class of real estate without getting hit with a significant tax burden.
A 1031 exchange, in other words, allows investors to defer paying capital gains taxes when selling an investment property by reinvesting the profits in a like-kind or a similar property. For this reason, this exchange is also known as a like-kind exchange.
A key rule of this tax-deferred transaction is that it’s generally for investment or business properties. Personal use properties, such as a home or a vacation home, don’t count. Securities and financial instruments, such as partnership interests, debt instruments, bonds, stocks, inventory, and certificates of trust, aren’t eligible for like-kind exchanges.
5 Steps to Master the 1031 Exchange for Real Estate Gains
A successful 1031 exchange requires careful planning and adherence to specific details and deadlines. The process might seem complex on the surface, but understanding the basics will make the exchange smooth.
Here is a step-by-step guide to help you master the 1031 real estate exchange:
1. Partner With a Qualified Intermediary to Facilitate the Exchange
A key rule of the 1031 exchange is that you cannot receive the proceeds from the sale of your relinquished property. A qualified intermediary receives and holds the amount in escrow instead.
The IRS requires investors to have an intermediary to oversee the transaction and its funds. You will have to hire one to comply with IRS regulations. You will owe all taxes on capital gains if you take ownership of the cash before the transaction is complete.
Real estate agents, certified public accountants (CPAs), attorneys, and investment professionals can serve as qualified intermediaries during the 1031 exchange. Be sure to choose your exchange facilitator carefully. You will lose all your money if they flake on you or go bankrupt.
2. Sell Your Property
As soon as you have a qualified intermediary in place, sell your investment property. Work with your qualified intermediary to initiate the exchange process. This entails entering a written exchange agreement and handing over the relinquished property to the buyer.
3. Identify Potential Replacement Properties
A 1031 exchange will be complete only if you buy a replacement property. Start identifying potential replacement properties after you sell your relinquished land.
But be quick, as you have a small window to identify potential replacement properties and eventually close on the replacement property.
You must identify the property you intend to purchase during capital gain tax-deferred exchange within 45 days of the sale of your investment property. RealtyMogul warns investors to act quickly, as this 45-day period isn’t flexible and cannot be extended.
Do not stick to one or two properties. Shortlist multiple options to increase flexibility. This will help you find a suitable replacement property within the stipulated period.
4. Purchase the Replacement Property
Evaluate shortlisted properties to ensure they meet your investment criteria. You should also consider the location, income potential, condition, and long-term prospects to decide which one to go for.
Conducting thorough research will help you find a suitable replacement property. Once you’ve found it, enter into a contract with the seller. At closing, the exchange facilitator will direct the proceeds from the sale of the old property to acquire the replacement land.
5. File IRS Form 8824
Last but not least, report your like-kind exchange to the IRS. You will have to fill out Form 8824, describing the properties and the people involved in the process.
To wrap things up, mastering the 1031 exchange is complex due to the limitations and regulations. However, it’s worth the effort. Among the most appealing benefits of like-kind exchanges are tax deferral, increased cash flow and income, and diversification of investment portfolio. As navigating the 1031 alone is challenging, leveraging the help of a tax advisor is advisable.
