As a budding investor, you want to make smart choices to maximize the return on investment.
The issue with that is that your profits could be subject to capital gains taxes. That’s why you’ll want to know about the 1031 exchange basics.
Capital gains aren’t just for Wall-Street tycoons. They’re for anyone who has made a profit from the sale of an asset. It’s applied the same to a car you fixed up and sold for a profit, stocks, or a home.
When you sell an investment property, a 1031 exchange is one of the best tools you can leverage to legally minimize your tax burden.
Read on to find out what a 1031 exchange is and how you can qualify.
What is a 1031 Exchange?
A 1031 exchange refers to the section of the IRS code which describes how you can defer taxes on “like-kind exchanges.”
A 1031 exchange lets you swap one investment property for another. If you meet the qualifications of the IRS provisions, you will have little to no capital gains taxes.
1031 Exchange Basics: How to Qualify
While a 1031 exchange sounds incredible because you have the chance to lower your taxes, you still have to qualify. There’s a lot to unravel in the IRS code when it comes to qualifying. Here’s what you need to know.
What’s Like for Like
At the core of section 1031 is the “Like for Like” part of the code. The first part of the 1031 exchange is that the property you’re selling must be used for business or investment purposes. Same with the property you’re buying.
The second part of like for like is that they have been similar in type, but not in quality. You can sell an investment property in a duplex and then upgrade to a multifamily dwelling.
These are the same type and can qualify for the tax deferment. The rule is broad, so you can do things like exchange land for a building, too.
You’ll want to know if it’s possible to exchange an investment property for another investment property in Europe. Unfortunately, both properties have to be in the United States.
There are deadlines to be aware of in the 1031 exchange. You can’t just sell a property and a few years later decide that you want to invest in another property.
You have 45 days from the day you sell your investment property to identify a replacement property that has similar or greater value.
You have to close on the property within 180 days of the sale of your investment property. These are very strict timelines that you must adhere to. Otherwise, you will not qualify for the exchange.
The Qualified Intermediary
When you sell your first property, you don’t touch your proceeds at all. If you do, that counts as taxable income. You need to have a “Qualified Intermediary” to do the exchange.
The intermediary holds the funds, kind of like an escrow officer, and releases them to the seller of your replacement property.
You’ll Have to Pay the Taxes Eventually
It’s important to remember that the tax on a 1031 exchange is deferred, not eliminated. If you sell your replacement property at a profit and cash out, you’ll have to pay taxes on the capital gains.
You can hold on to your replacement property for as long as you like and continue to defer the taxes.
A Failed 1031 Exchange
There are instances where you have a 1031 exchange that fails. If that happens to you, rest assured that you can still reap some tax benefits. Read more here about how you can still benefit from a failed 1031 exchange.
Changes in 2018
With the Tax Cuts and Jobs Act, you can imagine that there are significant changes to the tax code across the board.
The 1031 exchange is no exception. The big change to the 1031 exchange is that it now only applies to real property. Real estate exchanges still apply and qualify for the tax benefits.
Personal property now has a lot more limitations to count as a 1031 exchange.
Under these limits are intangible assets, such as patents, intellectual property, and franchise licenses. Tangible personal assets that no longer qualify include livestock, collectibles, artwork, vehicles, boats, railcars, and aircraft.
You can be sure that Congress and the IRS aren’t done making changes to the tax code. You can expect more tweaks to the tax code.
You’ll want to keep an eye out for changes and tax notices, especially as taxpayers navigate the first tax season under the new laws.
Examples of 1031 Exchanges
The IRS code can be difficult to interpret. These examples will show you how a 1031 exchange works in action.
Jimmy Doe bought an investment property for $400,000. He’s had it for a few years, and he’s about to sell it for $600,000. That leaves a $200,000 profit that’s taxable.
He contacts an intermediary before the sale of the property to find a like replacement property. He finds a replacement property within 45 days of the sale and closes within 180 days.
With that qualifying exchange, he saved a lot of money in capital gains taxes. In this instance, Jimmy just reinvested the proceeds of his first property.
Take Advantage of 1031 Exchanges
We all dream of legally lowering how much taxes we owe on our income and our investments. Learning the 1031 exchange basics gives you the power to continue to make your money work for you.
That’s a lot better than making your money work for the government.
To make a 1031 exchange work, it’s best to have a qualified intermediary early in the process.
You’re going to have a lot of questions going through your first 1031 exchange, and it’s critical to have someone to walk you through the process.
You’ll get to enjoy the tax benefits that you deserve. Want more great investment tips? Check out this article on medical marijuana stocks that are worth your attention.