What You Need to Know About a 1031 Exchange
A 1031 exchange is a way for investors or property owners to sidestep capital gains taxes by purchasing a similar property to that of their last one. It's a convenient option that can save people money (at least in the short-term) as they grow their income and assets. However, it's definitely not the right choice for everyone. Use this short guide as a way to figure out if this rather complicated choice is one that can work for you.
The 1031 Exchange is named after a section of the tax code, and it's becoming more popular by the year for real estate investors. Investors can sell their property for a property of the same price. This benefit can't be applied to primary residences, though there are ways to apply it to the sale of vacation homes. It also can't be applied to personal property (e.g., boats, jets, etc.) anymore.
The idea is for the government to encourage homeowners to continue investing by giving them a break on capital gains tax. So if their last property made $50,000 in capital gains, they won't have to pay up to 20% taxes on that figure. The IRS doesn't want any money lost in this transaction, which is why home owners need to buy property similar in value to that of the one they're selling. In a true 1031 exchange, the resulting taxes will be either limited or nonexistent.
The IRS has put a few conditions and terms on the 1031:
- No limits: 1031 exchanges can be done on as many times as the property owner pleases.
- Deferred taxes: 1031 only defers taxes from the sale rather than eliminating them. Eventually, the property owner or their descendants will have to pay the IRS. However, for long-term investors, they can use this to cut down their taxes to a single payment.
- Depreciation matters: Those who claimed depreciation to their property may have to pay a depreciation recapture gain. The IRS essentially quantifies the depreciation and then taxes it as if it were regular income. For the most part, it's an unusual tax to pay. However, it may apply if property owners are exchanging a nicer property for a failing one.
The Rules Aren't Clear-Cut
Few real estate experts would advise property owners to go through a 1031 exchange on their own. Even those who have successfully completed an exchange in the past will face new tax rules this year. For example, some property owners may think they need to purchase the same type of property they had before. So if they had an apartment complex, they'd have to buy another apartment complex to complete the transaction. However, this isn't so. The rules have more to do with the price of the properties, but there are clauses in the tax code that will challenge the eligibility of certain properties for sellers who aren't careful.
There Is Some Flexibility
For sellers who can't find a buyer or the perfect property to buy right away, there are ways to complete a delayed exchange. This step requires someone to hold the money until both the purchase and the sale goes through. The Qualified Intermediary is usually a CPA, real estate agent, or lawyer. Once the property in question is sold, the seller has 45 days to specify which property they're planning to buy. The owner can actually specify up to three properties (so long as they actually buy one of them). There are ways to specify additional property sites, but buyers will want to clarify these properties with an advisor first. As soon as the buyer closes the sale of their old, they have 180 days to acquire the new one.
Cash and Debt
If there's any leftover money at the end of the sale, the intermediary will hand it over at the end of the sale. However, this additional income will typically need to be reported to the IRS and taxed like a capital gain. Similarly, liability can also be taxed as well. If the seller drastically decreases their liability, this can be qualified as a financial (and taxable) gain. So sellers don't have to cash leftover at the end of the sale to accrue additional taxes. Again, it's another reason why East Memphis property owners need professional help to make a 1031 exchange happen.
A 1031 exchange has been a lifesaver for savvy investors who want to put their money into new ventures rather than back into the government coffers. However, the 1031 exchange is not a simple swap by any stretch of the imagination, which is why it helps to have an expert on your side.