To understand 1031 exchanges, avoid these common misconceptions.
If you want to build a real estate empire, you need to understand 1031 exchanges. If you make a profit when you sell real estate, you’ll need to pay federal capital gains tax, which can be as high as 28%. You may also need to pay state tax, depending on where you live. That’s why real estate investors take advantage of the 1031 exchange. Unfortunately, some people miss out on this opportunity simply because they don’t understand them. Here are the most common questions that cause confusion when selling an investment property.
Question 1: To qualify for a 1031 exchange, don’t I have to buy and sell a property at the same time?
No! You can delay the exchange until you find a replacement property as long as you follow the rules. A qualified intermediary must hold the proceeds on your behalf during the exchange. Once you close on your sale, you have 45 calendar days to identify a possible replacement property and 180 days to close escrow.
Question 2: Do I need to reinvest all of the money from the sale of a property?
Not always. You can buy a lower value property, or choose to withhold some of the proceeds. However, you would be subject to taxes on the difference.
Question 3: Can I do a 1031 exchange if I sell my personal home?
Tax-deferred exchanges are for investment property only. You cannot 1031 exchange your personal primary home. There are other tax laws that relate to avoiding capital gains tax for primary residences.
Question 4: Can I exchange into more than one property?
Yes! You can use the profit from one property to purchase multiple replacement properties. You can buy or sell any number of properties, provided you follow the rules.
Question 5: Why shouldn’t I just pay the capital gains tax now?
Capital gains tax can be much higher than you think. It can range from 15% to as much as 23.8%, depending on your income and the state you live in. It also usually includes the recapture of depreciation tax of 25%. For this reason, you could potentially have a combined capital gains tax of 35% to even 40%.
Question 6: What is a “like-kind” property?
Determining what qualifies as “like-kind” property can be problematic. For this reason, it’s important to consult a qualified intermediary. The IRS states: “Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”
Question 7: How many times can I do a 1031 exchange?
As long as you hold your
properties for two years or longer, there’s no limit to the number of times you
can do a 1031 exchange. Essentially, you could keep selling properties and buy
like-kind properties as much as you want. This is the exact strategy that allows
real estate investors to build value over time.
All things considered, anyone who makes a profit from
selling investment property should think about a 1031 exchange because it lets
you generate higher returns by trading up to a higher-value property or
portfolio of properties. It also helps you take advantage of other
opportunities that may better align with your investing goals. As a result, you
don’t pay tax until you sell the new property — or you can defer taxes with
another 1031 exchange.