If you have been holding on to a real estate investment or perhaps a former primary residence where you no longer can offset capital gains with a new home purchase, a 1031 exchange may be the answer that you are looking for to defer capital gains taxes. A 1031 Exchange is a tool used in the sale of real estate in order to defer capital gains taxes on the sale of real estate. This tool works best for people who want to sell an investment property but don’t want to pay the capital gains and want to continue to invest in real estate or other investments.
In order to capitalize on this tool offered by the IRS, a real investor must plan well in advance or the ability to exchange the property and defer the capital gains tax will be lost forever. I had the chance to discuss the topic of a real estate 1031 exchange on 1150 KKNW AM radio and you can listen to that segment here:
What transactions Qualify for a real estate 1031 Exchange?
Not all investments qualify for a 1031 exchange and in order to be eligible for a 1031 exchange, three criteria must be met.
(1) The investment property purchased must be of equal or greater value than the investment property sold.
(2) All proceeds from the sale of the initial investment must be used on a replacement property
(3) The property being purchased and the property being sold must be considered like -kind property. Also keep in mind that, like kind property does not mean it must be a similar property, only that it must be an investment property for another investment. So, if you are trading a condo for a single family house or a REIT investment for example that would be ok.
What is the timeline to Complete a Real Estate 1031 Exchange?
Once the initial property is sold, a buyer of a new property will have 45 days to identify a replacement property and 180 days to acquire the replacement property.
What are the benefits of a Real Estate 1031 Exchange?
- Deferral of taxes, including federal capital gains tax, state capital gains tax, net investment income tax, and depreciation recapture tax
- Maximize cash flow potential and investment money
- Eliminate inheritance and estate tax for beneficiaries
- Reduce risk through diversifying your real estate investments
- Invest in properties that do not require active management
- Access to different markets and property types
How Does a Real Estate 1031 Exchange work?
The first step is to identify a qualified 1031 exchange qualified intermediary to make sure your transaction is set up properly. It is necessary to make sure that the Sellers don’t actually touch the funds from the proceeds of the sale as the intermediary must sell your property on your behalf, buy the replacement asset and then transfer the deed to you.
Next you will want to get your investment property on the market with a gameplan of completing a 1031 exchange. Ideally you will have identified your exchange property and you will need to work with a qualified intermediary who holds the sale proceeds for the exchanger in order to complete the exchange.
Having to work with an intermediary can add some additional costs to a typical real estate purchase and sale transaction but it is not substantial depending on the services provided. Some intermediaries can even assist with finding you a real estate broker to sell your properties and identifying new investments that may suit your needs.
After the purchase and sale of the properties is completed, information will need to be provided to the exchangers or their CPA for tax purposes in order to make sure the benefits of the 1031 exchange are complete.