What is a 1031 Exchange?
Usually, when you sell a property, the federal government will charge capital gains taxes anywhere from 15% to 20% on the proceeds from that sale. However, if you are selling your property and want to use those proceeds towards another, similar property, you can conduct a 1031 exchange (otherwise known as a like-kind exchange) to avoid paying capital gains taxes on the sale.
There are many 1031 exchange benefits, but the main one is deferring the money you would’ve spent on taxes. You can conduct as many 1031 exchanges as you like, as long as the properties are similar in function. For example, you would trade a vacation home for another vacation home, not for a long-term investment property or personal residence. Also, keep in mind that a qualified intermediary must hold your capital gains in escrow during this transaction. You will not be able to access those except to purchase the second property that you are exchanging your old one for.
It’s important to note that 1031 exchanges do not save you money on capital gains and technically only defer those taxes until you sell your last investment property, at which point you would pay once on your long-term capital gains.
Why Do a 1031 Exchange?
As mentioned above, avoiding capital gains tax during a property sale is the main reason why investors choose this strategy. You’re able to postpone paying that tax indefinitely, which is a great advantage to many real estate investors because you can reinvest those funds immediately into your portfolio.
Also, having a third party, in this case a qualified intermediary, handle the sale of your property is certainly an advantage. These QIs have a range of responsibilities and allowing a professional to conduct tasks like handling funds and communicating with the title company can save you time and headaches.
Another benefit of 1031 exchanges is that they reset your depreciation schedule. If you’ve depreciated your property over 30 years already, conducting a swap with a 1031 exchange will reset that schedule to zero, allowing you to continue to take deductions for the general wear and tear of your property.
Most landlords who utilize this method can increase equity and grow their real estate portfolio as a whole. Exchanging properties allows investors to invest in a new market or kind of real estate, freeing up space for diversification and growth in your real estate portfolio.
Potential Risks
As with any kind of investment strategy, there are some risks that can come with conducting a 1031 exchange.
Since these exchanges tend to be scrutinized more closely by the IRS, you should take extra care to follow all rules and regulations. Foregoing procedures or violating any of the IRS’ rules could land you in legal trouble.
Also, some taxes may still apply. You’ll get taxed on the property sale if you do not conduct the exchange successfully. You will also be taxed on the difference between your two mortgages if the new property has a mortgage that is lower than your old one.
It’s a good idea to hire a tax professional to handle your documentation if you’re using this method, since your tax documentation becomes slightly more complex. You’ll need to file IRS form 8824 alongside your tax return, which requires you to document all the details on your exchange. Keeping track of the information involved in these exchanges can be difficult, so if you have the option to hire a CPA, it would be worth your money to do so.
A common question is does 1031 exchange avoid state taxes? In most states, the answer is yes. However, not all states allow for this tax deferral, so make sure you check with your local laws to see if you reside in one of them before starting the exchange process.
Conclusion
If you are looking for ways to defer taxes and reinvest in your real estate portfolio, 1031 exchanges can be beneficial for you. However, it’s always a good idea to seek out guidance from professionals like qualified intermediaries who have lots of experience with the 1031 exchange process and any associated IRS rules and regulations.