Understanding 1031 exchanges is important if you plan on buying and selling investment or rental properties. The name “1031 exchange” is derived from Section 1031 of the Internal Revenue Code, and it can save you a lot on capital gains taxes. No one wants to pay more taxes than necessary, and there’s only one way to make sure you are keeping your taxes as low as possible on this particular kind of transaction. It’s good to know the rules so you can play by them.
You Qualify for a 1031 Tax Exchange When:
- You’ve turned your primary residence into a rental property where your tenants have possession of the property AND you no longer occupy the property. When you sell this property you can reinvest in another piece of like-kind real estate.
- You sell an investment property and reinvest in another investment property (or properties) which you formally identify within 45 days (more about the procedure here)
The Advantages of 1031 Tax-Deferred Exchanges
Defer Capital Gains Taxes on the Sale
The main reason real estate investors do 1031 exchanges is to defer paying tax on the sale and use that cash as equity in the new property, as a wealth building technique. In this manner, the tax is “deferred” until sometime in the future when the new property is sold. It’s important to note that a tax deferral is not the same as a tax exclusion, such as when you sell your principal residence.
Investors can take advantage of the 1031 tax-deferred exchange to acquire a more valuable investment property. By utilizing the money they would have paid to the IRS in taxes, they can increase their down payment and improve their overall purchasing power to acquire a more expensive replacement property. Thus, leveraging their cash and continuing to build wealth through real estate investment.
The Ability To Convert The Investment Property To A Personal Residence
As a part of your retirement planning, you can acquire investment real estate to retire in several years in advance. After holding property as an asset for a few years, you can elect to make the property your primary residence. No taxes are triggered until you sell that property in the future. Although the property will likely sell as a primary residence, there’ll be taxation later because the real estate was acquired as part of a 1031 exchange. You can see why this option is one of the sweetest advantages of 1031 exchanges.
Increase Cash Flow
Many investors hold non-income producing real estate and are looking to exchange it for income producing residential or commercial property. This increases cash flow and enables them to live a better lifestyle especially as they head into retirement years.
Unlimited Tax Deferral
Repeated tax deferrals may be the most appealing advantage here. There is no time limit on taxes, and you’re free to transfer the tax obligation to replacement properties numerous times.
To sum it up, you can save a lot of capital gains taxes with 1031 exchanges, if your transactions qualify. The key is to make sure you follow the IRS rules.