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 Internal Revenue Service (IRS) as long as the property is not a primary residence.
Some believe that one of the most significant benefits of real estate investing is the tax benefit. Investors can complete a 1031 exchange to buy and sell like-kind properties to defer capital gains taxes. Real estate can be an income-producing investment through appreciation, rental income, and other passive income avenues.
When a property is sold, the sale could face a significant capital gains tax on the profits. Thanks to Section 1031 of the Internal Revenue Code, investment property owners can defer the capital gain tax from their property sale.
Despite the advantages of this tax law, it can be complicated to understand. This confusion can be about what a 1031 exchange is and its various rules and regulations. Investment property owners have strict rules to follow and deadlines to meet to have a successful 1031 exchange and avoid generating a taxable event.
What Is a 1031 Exchange?
A 1031 exchange is the trade of one real estate property for another. Though this property swap would typically be taxable as a sale, a 1031 exchange means you can defer tax when the exchange is made.
This type of real estate rollover allows the gain from a sale to roll over to a new property, effectively allowing an individual to transfer the gain and postpone tax.
1031 Exchange Rules and Regulations
1031 exchanges follow a rigid structure as defined by the IRS. Failure to meet the regulations may disqualify your exchange from the 1031 tax deferral benefits.
One qualifier of a 1031 exchange is that the properties must be like-kind. Like-kind exchanges involve exchanging a business or investment property for another business or investment property, which does not require the investor to recognize a gain or loss. The properties are considered like-kind if they are of the same character or nature, but they can differ in quality or grade. For example, you can exchange a renovated apartment building for an unimproved strip mall. Most real properties are like-kind.
The Tax Cuts and Jobs Act of 2017 defined that only real property or real estate can be used in a 1031 exchange, disqualifying assets like equipment, aircraft, and franchise licenses. The 1031 benefits only apply to investment and business properties.
Both properties must be in the United States. Section 1031 regulations cannot be applied to international assets, and a property in the United States and one in another country are not considered like-kind.
No limit exists for how often you can complete a 1031 exchange. You could roll over the gain from one investment property several times, deferring paying tax until you ultimately sell the property and receive cash or pass it on to your heirs to receive a step-up in basis.
Example of a 1031 Exchange
Though the 1031 exchange process can be complicated, the capital gains rollover and potential tax savings can benefit real estate investors. Consider the following example to understand how this process works:
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 taxes.
Compare the following figures for a standard sale versus a 1031 exchange. In this basic example, we’ve used a 30% tax rate, which includes capital gains, net investment income tax, and depreciation recapture. This figure could be more or less than your actual situation, depending on your tax bracket, state, how long you’ve owned the property, and other factors. This example also excludes capital improvements and sale-related expenses.
With a standard property sale, you would have:
- Net proceeds: $500,000
- Taxes due: $120,000
- Reinvestment capital: $380,000
See how a 1031 exchange can increase your capital while deferring your taxes:
- Net proceeds: $500,000
- Taxes due: $0
- Reinvestment capital: $500,000
With a 1031 exchange, 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 proceeds are used to fund new investment properties, which may generate cash flow and appreciation.
These 1031 exchanges are important because they can help real estate investors create more wealth. Real estate investors may use 1031 exchanges to buy more lucrative properties and potentially reap the rewards.
Consult 1031 Crowdfunding to Learn About 1031 Exchanges
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, so 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 be consulted. 1031 Crowdfunding has a real estate investment platform to help our clients execute a successful 1031 exchange. Contact us today to learn more.
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