Real estate investments come in several different shapes and sizes. Whether you’re buying a house, townhouse, condominium, vacant land, strip mall, hotel or apartment building, it is considered a real estate investment by the IRS.
Some believe that one of the most significant benefits of real estate investing is the tax benefit. However, if the property is sold, the sale could face a significant capital gains tax on the profits.
Thanks to Section 1031 of the Internal Revenue Code though, the payment of income or capital gain tax on the sale of property can be deferred. A properly structured 1031 exchange allows an investor to sell a property, reinvest the proceeds in a new property and to defer all capital gain taxes. IRC Section 1031 states:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Despite the existence of this tax law, it is one of the most underutilized sections of the tax code. Part of that may be due to a confusion between name and definition. The gain from a sale is rolled over to a new property, effectively allowing an individual to transfer the gain and postpone tax. Perhaps the 1031 exchange would be more aptly named a 1031 rollover to signify a simultaneous transfer of property.
Consider the following example. If someone purchases a piece of real estate for $100,000 and then sells it for $500,000, the individual is subject to paying capital gains taxes on the $400,000 profit and could lose nearly $120,000 to capital gains taxes.
With a 1031 exchange though, the full $500,000 could be used to purchase one or more new properties, and there would be no capital gains taxes at the time of sale. The sale’s proceeds are used to fund new investment properties, which in turn, may generate cash flow and appreciate.
These 1031 rollovers are important because they can help real estate investors create more wealth. Real estate investors may use 1031 exchanges to buy bigger and better properties and potentially reap the rewards.
The big takeaway when considering a 1031 exchange is that since the investor is exchanging one property for another of “like-kind,” there is nothing received that can be used to pay taxes. All gain is tied up in the exchanged property, so no gain or loss is claimed for income tax purposes.
A 1031 exchange can be a lucrative tax and investment strategy and an estate planning tool. An investor could potentially continue deferring capital gains on investment property indefinitely. Capital gains taxes on profits can run high when state and federal taxes are combined, it is worth it to take the necessary steps to avoid the loss and save for future investments.
These rollovers can be complex and are not recommended for the “do-it-yourself” investor, an expert should always be consulted.