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1031 Tax Exchanges: How Do They Work?

1031 Tax Exchanges: How Do They Work?

1031 Exchanges – How do they work?

Many of our clients are interested in real estate investing, but are unsure where to start.  Perhaps they inadvertently became a landlord after keeping their first condo or starter home.  Or, many have thought about the what ifs of buying an investment property and how they can maximize their returns.  Either way, 1031 Exchanges are a popular way to get the most of your investment in real estate.

As the old saying goes, “Nothing is certain except for death and taxes.”  While taxes are unavoidable, tax deferrals are one of the most effective tools in asset management. By postponing the payment of your tax owed, you allow your investment to generate more income.  Your portfolio longevity also extends as tax-advantaged assets are usually availed in higher amounts, and higher amounts result in higher gains that exceed your estimated income and investment years.  Frankly put, less taxes paid now = more money to invest now.

With current tax laws, most people are aware the first $250,000 profit of a primary residence sale is not taxed.  This amount jumps up to $500,000 for a couple.  To be considered a primary residence, you must have lived in the property 2 of the last 5 years.  This, potentially, could allow a homeowner to lease their property for 3 years, sell the property, and make a profit tax free.  Should a previous home be kept as a rental longer, profits now risk the capital gains tax.  A great way to avoid this when ready to sell is to use the 1031 Exchange and put that money in another investment property.

The IRS code which is specific for real estate investing are 1031 Like-kind exchanges. They are specifically used for real estate investing; primary residences do not qualify.  In the event where you want to exit a holding and exchanging property, it is most definitely possible for capital appreciation. When you are ready to sell, it will likely be of higher value from the original purchase price. The difference between the price of the asset back then and its appreciated value now becomes your capital gain. Without the 1031 exchange investment, your earnings from the transaction will be immediately deducted of its tax implications. When you utilize 1031 exchange investments, you are deferring taxes for capital gains and depreciation recapture. Here’s how it works:

1031 exchange investments allow you to find a like-kind replacement property that is similar in nature and in value to what you have just sold. Your gains from the transaction of exchange will be considered as capital to your new like-kind exchange investment, so it is not truly deemed as a gain at the moment. In 1031 exchange, it is truly a cycle of passing earnings from one investment to the other, and in each investment, your proceeds increase every time which becomes a driver for income generation.

What are the guidelines in qualifying for a 1031 tax deferral?

  • Properties being exchanged must be used for investment, rental, and commercial purposes
  • Only like-kind exchanges are accepted in the application for 1031
  • Instead of selling, investors must be exchanging the properties

What are the steps in applying for a 1031 exchange investment?

  • Within 45 days, you must identify a potential replacement property. 

You can present up to three properties. If you wish to identify more, there is a 200% rule where the aggregate value of the properties you have chosen should not exceed 200% of the original property. Additionally, a 95% rule governs the case where you can identify multiple properties given that the total fair market value of these properties is equivalent to 95% and are already exchanged by the end of the given period. 

  • Hire a reputable and qualified intermediary to handle the legal and financial requirements of 1031. Your broker or lawyer must be truly trust-worthy as the money from the exchange can only be held by an intermediary
  • Close the transaction by exchanging your relinquished property.
  • Make sure to acquire the approved replacement property within the 180-day period.

Written by Property Manager and Realtor with MY Townhome & MY Home Leasing – Laura Grant