Should you defer capital gains taxes with a 1031 exchange?

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Selling real estate can generate a large profit, but it also comes with a large tax bill. That’s where a 1031 exchange helps: by giving you a tax-deferred benefit. But 1031 exchanges are complicated and have strict requirements, meaning they’re not for everyone. Also known as a like-kind exchange, a 1031 exchange allows real estate investors to defer paying capital gains tax on the sale of a property on one condition: you must buy a similar property within a specified period, essentially an “exchange” investment property for another.

“In a nutshell, you’re exchanging one property for another, and the new property takes the base of the previous property,” said Marianela Collado, CEO of Tobias Financial Advisors.

Because a 1031 exchange is a complex tax strategy, it is typically used by sophisticated investors who plan to continue buying and selling properties that will increase in value over time. It’s not something you should try to fix on your own. Keep in mind that a 1031 exchange does not eliminate your tax bill; you’re just kicking the box. So while you can defer your capital gains taxes for years, you’ll have to pay Uncle Sam once your replacement property sells.

How a 1031 exchange works

Typically when you sell business property you are taxed on your capital gains (the long term appreciation of the property) and over time you also have to pay tax on the recovery of the property. depreciation on the property (i.e. the income tax you normally have to pay on the gain realized on the sale). For taxable transactions over $250,000 in economic value, you generally have to pay a net investment income tax of 3.8%.

But if you want to sell an investment property and use the money from that sale to buy another property, you can use a 1031 exchange to avoid paying those taxes at the time of the transaction, thus deferring your tax bill.

Although the long-term goal of an investment exchange like this is to defer capital gains tax, real estate investors shouldn’t expect short-term money. A simple 1031 will not produce any income and will not give money to your bank account.

“You have to reinvest all the proceeds to defer paying tax on the entire gain,” Collado said. “In other words, you can’t just reinvest the gain.” For example, if you sell a property for $100,000 and the gain is $75,000, you must reinvest the entire proceeds of $100,000 to avoid paying tax on the $75,000.

When can you use a 1031 exchange?

In most cases, you can only use a 1031 exchange on business or investment property. Let’s say you own a beach house that you rent out regularly and earn a steady income from. This investment property would qualify for a 1031 exchange if you decide to sell it and buy a new, similar investment property.

However, if you have a residential property that you use as a holiday home and sometimes listing on Airbnb, you cannot use a 1031 to sell this property and buy a new tax-deferred vacation home. This is because the property will not be classified as an investment or commercial property.

Although a like-kind exchange must exchange one investment property for another, it need not be to identical property types; it works as long as the properties are comparable. So you can sell a holiday home that you regularly rent out and reinvest the proceeds from the purchase of parking…as long as that parking is for business purposes.

What factors should you consider?

You have a 45 day window to purchase a new property

One of the most common mistakes people make when attempting a 1031 exchange is missing the deadline to find a new property. You only have a small window of 45 days to identify your next investment, and you must close on this property within 180 days (which includes the 45 days). Otherwise, you will not be eligible for this exchange.

“Unsophisticated buyers and sellers struggle to meet deadlines,” said Matt Chancey, tax shelter and private equity consultant at Coastal Investment Advisors. Additionally, it is easier for buyers and sellers to take advantage of the lack of time someone experiences in a 1031 exchange, knowing that they only have 45 days to find a new property and 180 days in total to close. This means you could end up underselling your first property, overpaying for the second, or both.

You cannot add the profits from a real estate sale to your bank account

When you trade real estate, you cannot simply take the money you earn from selling the first property and deposit it into your bank account. It must be held by a specialist custodian called a Qualified Intermediary, an independent agent who facilitates a part of the exchange that real estate investors are legally not allowed to handle on their own.

“QI is essentially just a custodian that will hold your funds at the close of the real estate transaction. If you mix those funds or take an implied receipt, you are no longer eligible for a 1031 exchange,” Chancey said.

If you receive the funds before the trade is complete, you could end up triggering a massive tax bill for yourself, eliminating the tax deferral benefit.

You can find an IQ through an organization like the Federation of Exchange Hosts to help you find someone in your specific state – something that can be critical, as state and local taxes can vary widely.

You should consult experienced real estate professionals

Even for experienced investors, financial advisers recommend partnering with the necessary qualified professionals — such as a CPA, real estate attorney, or stockbroker specializing in 1031 exchanges — to avoid any mishaps.

“Don’t trip over pennies on the way to dollars,” Chancey said. “If you need a good real estate or tax lawyer, get one.” Additionally, one of the finance professionals you work with can often act as an IQ.

The bottom line for real estate investors

A 1031 exchange is a valuable tool for deferring capital gains taxes on investment properties, but it’s a strategy that requires intimate knowledge of the myriad types of taxes associated with real estate transactions. You should always hire professionals to walk you through the process.

And while a 1031 exchange is an effective way to defer taxes, once you’re ready to sell your last investment property and aren’t buying a new one, your tax bill will eventually be due.

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