As a real estate investor, you need to be aware of the 1031 exchange found in section 1031 of the U.S. Internal Revenue Code.
It is important that you understand these exchanges because by using it in the right way it can allow you to save taxes every time you sell a property and generate a profit.
Before getting into how it works it is important to understand clearly what is a 1031 exchange.
What is a 1031 exchange?
Basically, this part of the Internal Revenue Code allows you to avoid paying capital gain taxes.
But it is not as simple as it sounds. To be able to use this exchange you need to sell an investment property and reinvest the money and profit you earned in this sale in a like-kind property of equal or greater value.
You also have no limit on how many times you can use a 1031 exchange or how frequently you can apply it.
There are some timings you need to take into consideration, but we will get to that later in this article.
1. There are special rules for depreciable properties
When you sell a depreciable property, it can generate a profit called depreciation recapture that is normally taxed.
Usually, you can avoid this recapture if you are swapping one property for another, but if you try to exchange one property with a building for a property without one, the depreciation for the building will be recaptured as ordinary income.
2. Keep in mind the timing rules
This 1031 exchange seems like a simple thing to do, right? Just swapping one building for the other.
But finding a person or company with a like-kind property that wants a similar property in exchange is not so simple and fast.
In these cases, the exchanges get delayed. Therefore you will need an intermediary that can hold the cash you earned after selling the property and use it to buy a similar property for you.
You will need to consider two timing rules for a delayed exchange. First, you have the 45-day rule that says that within 45 days of the sale of your property, you must specify the replacement property to the intermediary.
According to the IRS, you can select three properties as long as you eventually close on one of them.
Then you have the 180-day rule where you must close the new property within 180 days of the sale of the old property.
3. Keep in mind the definition of a like-kind property
As mentioned in the beginning of this article, in order to qualify as 1031 exchange the property you are selling and the property you are thinking of acquiring need to be like-kind.
This means that both properties must be of the same nature. In the case of real estate it is a little more simple because you can exchange almost any type of property, as long as it is not your personal property.
4. You need to have the same Taxpayer
This is a basic documentation issue you need to consider when you are doing a 1031 exchange!
The tax return and the name on the title of the property that is being sold need to be the same as the tax return and titleholder that is buying the new property.
Just for you to know there is one exception to this rule: the case of a single-member limited company (SMLLC).
5. A taxpayer should not receive “boot”
In order to make the exchange completely tax-free some people try to give and receive “boot”. That is basically paying the difference when a property is worth less than the other, but this doesn’t make the transaction tax-free because the boot received is taxable.
And it is something you can do and actually, some people use it when they receive more value by paying the tax for the boot than the taxes for the capital gain of the property.
Is the 1031 exchange for you?
This exchange is usually the best option for many people involved in the real estate world, but you need to know all the exceptions, times, and ways to do it.
Because if you do not handle it well you can get confused and have problems with your taxes and you obviously do not want that.
If you can make it work this is a great way to reduce the amount of taxes you will need to pay as a real estate investor.
And if you need help understanding this exchange and making your accounting process work, we can help you.
At Terra Business Solutions we will give you the expert advice you need in order to reduce your taxes in a safe and legal way.
If this is something you think might help you, you can schedule a call with us.
Without any commitment, we can hear your needs and identify if we can help you reach your financial goals through the management of your accounting processes and accurate tax planning.
Are you interested? Click here to get a call with our experts.
I hope this was helpful for you and as a real estate investor you have been able to find the answers you needed. Talk to you soon.