What is 1031 exchange?
“Does it have something to do with investment properties?” Is usually the question I get. A 1031 exchange might be perfect for you if you are trying to sell an investment property to buy a new one. This exchange allows you to defer capital gains as long as you're purchasing a "like kind" property.
Understanding the intricacies can be daunting, but we can help guide you in the right direction. Have you heard that before? It's true because we do it for all of our clients for every situation. We will connect you with a qualified intermediary which is a professional third-party company that accommodates the exchange process and helps you avoid making any critical mistakes that could jeopardize your tax advantaged sale.
The main requirements for a 1031 exchange are: (1) must purchase another “like-kind” investment property; (2) replacement property must be of equal or greater value; (3) must invest all of the proceeds from the sale (cannot receive any “boot”); (4) must be the same title holder and taxpayer; (5) must identify new property within 45 days; and (6) must purchase new property within 180 days.
To understand how beneficial a 1031 exchange can be, you should know what the capital gains tax is. In most real estate transactions where you own investment property for more than one year, you will be required to pay a capital gains tax. This directly levies a tax on the difference between the adjusted purchase price (initial price plus improvement costs, other related costs, and factoring out depreciation) and the sales price of the property. The percentage that’s taxed on your capital gains depends on the tax bracket that you’re in. The 1031 exchange is defined under section 1031 of the IRS code, which is where it gets its name.
There are four types of real estate exchanges that you can consider when you wish to participate in a 1031 exchange, which includes:
- Simultaneous exchange
- Delayed exchange
- Reverse exchange
- Construction or improvement exchange
What Qualifies as Investment Property?
The property must be a business or investment property, which means that it can’t be personal property. Your home won’t qualify for a 1031 exchange. However, a single-family rental property that you own could be exchanged for commercial rental property.
How Do You Determine Equal or Greater Value in an Exchange?
The equity and market value of the investment property that you purchase will need to be equal to or greater than what you sold your current property for. If your property has a $300,000 mortgage on a $1 million home, the property that you want to purchase must be worth at least $1 million and you must have the same ratio (or higher) debt on the property.
Is it worth doing a 1031 exchange?
A 1031 Exchange allows you to delay paying your taxes. It doesn't eliminate your capital gains tax. Only if you never sell your 1031 exchanged property or keep on doing a 1031 Exchange, will you never incur a tax liability
How long must you hold 1031 property?
If a property has been acquired through a 1031 Exchange and is later converted into a primary residence, it is necessary to hold the property for no less than five years or the sale will be fully taxable.
What is the 2 out of 5 year rule?
The 2-out-of-five-year rule is a rule that states that you must have lived in your home for a minimum of two out of the last five years before the date of sale. However, these two years don't have to be consecutive and you don't have to live there on the date of the sale.
To determine your taxes related to capital gains, use this simple formula:
- Note selling price.
- Deduct selling expenses.
- Determine purchase price.
- Determine your basis: deduct #3 from #2.
- Calculate deductible depreciation.
- Deduct depreciation from basis = gains.
- Multiply your gains by the State tax rate.
If you are a real estate investor, these exchanges can be helpful for a variety of reasons. If you would like to purchase a property that has better estimated returns 1031 Exchange is a great tool.
Now that I've given you some information you can see that this process is very intricate and needs to be navigated by a professional. Contact us and I'll be happy to help.