If you own any real estate investments, you may be interested in a tax break called a 1031 exchange. A 1031 exchange, also called a like-kind exchange, essentially allows real estate investors to swap one property for another, while deferring capital gains tax.
A capital gain is the amount of profit made on the sale of capital assets (stocks, bonds, jewelry, coin collections, and real estate). The taxpayer who sells the asset is required to pay tax on that capital gain, in the tax year during which the sale occurred.
Capital gains tax rates for 2021 and 2022 can be up to 20% of the profit, depending on the income of the filer and the length of time the asset was owned. In a real estate sale, this capital gains tax can be substantial. The ability to change the form of their investment while deferring the capital gains tax payment can be very appealing to real estate investors.
However, in order for a 1031 exchange to be valid, the following rules must be upheld:
- Handling the Profits: Proceeds from the sale of the original property must be held in escrow by a third party, then used to buy the new property. You may not take possession of the profit during the process, or the 1031 exchange will not be valid.
- Like-Kind: The properties being exchanged must be considered “like-kind” by the IRS.
- 45 Day Rule: Within 45 days from the date of the sale of the original property, you must designate the replacement property that you wish to purchase and submit this in writing to the 3rd party who is holding the profits in escrow. You may designate up to 3 properties, as long as you eventually close on one of them.
- 180-Day Rule: You must close on the new property within 180 days from the date of the sale of the original property.
- Reverse Exchange: It is possible to purchase the new property before selling the old one and still qualify for a 1031 exchange, but certain steps must be followed.
- Boot: What if you have cash leftover in escrow after the purchase of the new property? This cash, paid back to you after 180 days, is known as “boot”. The boot will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
- Loans and Debt: You must consider any mortgage loans or other debt on the property that you are selling, as well as any debt that exists on the new property. Even if you don’t receive any boot, but your liability decreases, that can be treated as income from the sale.
- Principal Residences & Vacation Homes: The sale of your principal residence or vacation home won’t qualify for a 1031 exchange, unless the home is rented out for a reasonable time period and generates income.
While certainly a savvy investment strategy in building wealth, 1031 exchanges can be complex, even for seasoned investors. If you have questions about 1031 exchanges, leave a comment below or feel free to reach out to me directly. I’m happy to help!