If you are a real estate investor looking to maximize your returns while minimalizing your tax liabilities, you may want to consider turning to a 1031 exchange: a powerful tax strategy that allows real estate investors to reinvest their proceeds from one investment property into another without having to pay taxes on their profits immediately. There are many benefits to a 1031 exchange, but there are also strict rules to follow to ensure of a successful exchange. As I go over some of these rules, keep in mind that it is important for investors to consult with a qualified tax professional to ensure a successful 1031 exchange and avoid any tax penalties.
The property being sold, and the property being purchased do not have to be identical but must be like-kind. These properties also must be used for investment purposes and not for resale or personal use. There is a broad range of exchangeable real properties. Someone who owns raw land could exchange for a commercial building or industrial for residential. Simply put, you can only exchange your real estate investments for other real estate investments. This is designed to keep investors from exchanging real estate for other investments like stocks or bonds.
Timing is another crucial factor involved in the 1031 exchange process. It’s important to abide by the identification period and the exchange period. The identification period implies that the investor must identify the potential replacement property within 45 days of the sale of the original property. The exchange period is when the transaction of the replacement property must be closed by. You have 180 days from the sale of the original property to close on the replacement property. If you miss either of these deadlines, prepare to be held liable for capital gains taxes on the first transaction.
There is no “downsizing” with 1031 exchanges. The rules of the 1031 exchange require the replacement property to be of equal value or greater than the original property. This means if you sell the original property for $350,000 you can’t purchase a replacement for $300,000 and pocket the additional $50,000. The entire amount you receive from the sale of the original property must be used to purchase the replacement property. Otherwise, capital gains taxes will apply to the entire applicable capital gain.
You should also know that all of this must be done with a qualified intermediary (QI) facilitating the exchange. The QI will hold the proceeds from the sale and use them to purchase the replacement property. If you were to personally handle the proceeds from the original sale, this would immediately trigger the capital gains tax liability, regardless of all other rules being followed.
There are several ways to structure a 1031 exchange and there are many more requirements and restrictions to abide by. As I mentioned earlier, it is very important to have a tax professional guide you through to ensure compliance with all rules and regulations. It is also recommended to work with an experienced REALTOR® who has knowledge and expertise in 1031 exchanges to assist in selling and purchasing these properties.
Lastly, remember that you wouldn’t be who you are today without your mother’s love and guidance. Happy Mother’s Day to all of the wonderful moms out there. Until next week!
Eve Leombruno, 2023 MBOR President