If you are aiming to be a real estate mogul, you must first be familiar with the 1031 exchange. Earning profit from selling real estate requires you to pay federal capital gains tax, which can be as high as 28%. Some states also require payment of sales tax. A 1031 exchange allows real estate investors to defer paying capital gains and potentially build wealth through real estate investing. Unfortunately, some people miss out on this opportunity simply because they are not familiar with this strategy. In this article, we will answer the most common questions in selling an investment property using 1031 exchange.

Question 1: What is 1031 Exchange?

A 1031 Exchange is another term used to discuss Section 1031 of the U.S. Internal Revenue Service’s tax code. This code is a strategy that allows investors to exchange one investment property for another so that they may be able to defer capital gains (or losses) that they would otherwise have to pay at time of sale. Doing a 1031 exchange allows the taxpayer to sell a piece of property and purchase another “like-kind” piece of property without depleting the cash flow from the sale due to capital gains tax. Section 1031 applies to “property” beyond real estate, but many 1031 cases deal with buildings and land.

Question 2: What does “like-kind” property mean?

The term “like-kind” can be confusing even for those deemed to be knowledgeable about the real estate business. The IRS defines it as follows: “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.”

However, the rules can be quite liberal in that an investor can exchange an apartment building for raw land, or a ranch for a mall. There are even instances where you can even exchange one business for another, such as exchanging a restaurant into a hotel. Beware though, if a property is not actually “like-kind”, the IRS will tax the full amount of the sale but an investor may not find out until they file forms to claim the 1031 exchange tax advantage. As such, it is smart to hire the services of a professional.

Question 3: To qualify for a 1031 exchange, do I have to buy and sell a property at the same time?

Not really. The exchange may be delayed until such time that a replacement property is available, provided that you abide by the rules. In the meantime, a qualified intermediary will hold the proceeds on your behalf during the exchange. As soon as you close the sale, you are given 45 calendar days to identify a possible replacement property and 180 days to close escrow.

Question 4: Do I need to reinvest all of the money from the sale of a property?

Not all the time. You have the option to purchase a property of lower value or withhold some of the proceeds from the sale. Bear in mind that you must pay the taxes on the difference.

Question 5: Can I do 1031 exchange if I sell my primary home?

No. Tax-deferred exchanges are only applicable for investment property. 1031 exchanges do not apply to primary homes. However, certain tax laws exist to avoid capital gains tax for primary residences.

Question 6: Can I exchange into several properties?

Absolutely! You can maximize the profit earned from one property in order to invest in multiple replacement properties. You have the option to buy or sell any number of properties, for as long as you follow the rules. It does not matter how many properties you are exchanging in or out of (1 property into 5, or 3 properties into 2) as long as you go across or up in value, equity and mortgage. However, exchanging into more than three properties should be done within the time and identification restraints of section 1031.

Question 7: Should I just pay the capital gains tax now?

The amount of capital gains tax is not to be taken lightly. It can range from 15% to as much as 23.8%, according to your income and the state you live in. Most of the time, it also includes the recapture of depreciation tax of 25%. As such, you could potentially have a combined capital gains tax of 35% to even 40%. Therefore, timing is important.

Question 8: Can I get back the initial down payment on a property I am selling?

No, the IRS takes the position that the first money out is theirs. In other words, you cannot be reimbursed your initial investment without incurring tax exposure. It is possible to receive money; however, any funds received will be taxed.

Question 9: Can I get back the initial down payment on a property I am selling?

No, the IRS takes the position that the first money out is theirs. In other words, you cannot be reimbursed your initial investment without incurring tax exposure. It is possible to receive money; however, any funds received will be taxed.

Question 10: Can I do a 1031 exchange several times?

There is no limit to how many times you can do a 1031 exchange provided that you hold the property for a minimum of two years, specifically in a “related party” exchange. As such, you could keep selling properties and buy like-kind properties as much as you want. A 1031 exchange has been used by smart real estate investors as a tax-deferred strategy to build wealth.

Anyone who aims to earn from selling investment property should seriously consider a 1031 exchange because trading up to a higher-value property yields higher returns of investment or builds your portfolio. It also helps you take advantage of other opportunities that may better align with your investing goals. Because you don’t pay tax until you sell the new property and you have the option to defer taxes with another exchange, it can be a worthy tax planning tool.

The rules for 1031 exchanges can be complex, so make sure that you utilize a competent qualified professional who can help you navigate all the rules and requirements.

If you have questions about real estate matters, talk to our real estate attorneys at Moschetti Law Group. Call 888-664-1848 for an initial consultation.

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