If you’re an experienced investor, you’ve likely encountered capital gains tax on more than one occasion. Capital gains taxes can seem like a significant detriment to your earnings when you’re trying to optimize your profits with investments. Many investors look for ways to reduce these taxes to receive the highest possible profits from their sold assets.
Completing a 1031 exchange is a way to defer capital gains taxes on real estate profits. With the potentially high capital gains tax rates, this possibility can seem attractive to all calibers of real estate investors. Understanding this tax deferral method can help you leverage 1031 exchanges for lower tax payments on your annual return.
What Is the Capital Gains Tax?
Capital gains tax is taxation levied on the profits you earn from selling an asset. The Internal Revenue Service (IRS) recognizes capital gains as a form of income, which is why it levies taxation upon it. As an investor, you’ve likely encountered capital gains tax many times. You can calculate capital gains tax with factors like your personal income, filing status and length of asset ownership.
It’s essential to recognize that capital gains tax only applies to asset profit, not the total earnings from a sale. You have to compare the selling price to the purchase price to determine the value that receives taxation. For example, if you purchase an asset for $50,000 and sell it for $70,000, the capital gain is $20,000.
Capital gains tax only applies to realized profits, meaning you must physically sell the asset. An unrealized profit — often called paper gains and losses — is money you could earn if you sold the asset. In the above example, you bought an asset for $50,000. If you discover this asset is now worth $70,000, but you don’t sell, you have an unrealized gain of $20,000.
Capital gains fall into two categories — short-term and long-term. The category will determine how the IRS taxes the profit. These designations are essential in understanding capital gains tax because they can drastically influence the amount you owe to the IRS. In some cases, you may even owe more in taxes than you earn in profit.
When Do You Incur a Capital Gains Tax?
You incur capital gains tax any time you earn a profit on an asset you’ve sold. Capital gains taxes affect all types of assets, including property, stocks, bonds, antique art and any personal property you might sell.
Mutual funds also incur capital gains tax, but shareholders distribute the profits among themselves before you realize your individual profit. After this distribution, each shareholder receives a 1099-DIV detailing the total capital gain distribution and what amounts qualify as short- and long-term. The distribution reduces the fund’s net asset value but does not affect the total return.
You earn short-term capital gains when you sell an asset you’ve had for one year or less. Long-term capital gains are when you hold an asset for longer than a year.
When you earn short-term capital gains, you add the amount to your annual income and incur taxes through that value. Short-term capital gains can result in higher taxes than you typically owe, especially if your profits cause you to move up a tax bracket. Depending on the profit you earn and the taxes you face, this scenario may lead to more owed in taxes than the profit earned from a sale.
Long-term capital gains have a separate taxation rate. Most individuals will only pay 15% on their long-term capital gains. High income earners that exceed the 15% tax bracket face a 20% tax. Individuals who earn $40,000 or less annually will not owe any tax for capital gains.
How to Use a 1031 Exchange to Defer Your Capital Gains Tax
A 1031 exchange refers to IRS Section 1031, which involves a capital gains tax deferral when a property owner completes a like-kind exchange. This deferral occurs because the property owner makes a profit from one property and puts it directly into another, so the profit isn’t fully realized and is insusceptible to taxation.
Section 1031 identifies a series of requirements for these exchanges to make them qualify for the tax deferral. If you intend to defer capital gains tax, meeting each of these requirements is critical.
1. Find Qualifying Properties
A 1031 exchange will not apply to any property, so it’s essential to find properties that qualify before committing to the process. Most importantly, you must exchange real property for real property, and these properties must be like-kind.
The like-kind rule may seem challenging to work with, but it offers more flexibility than is apparent. Like-kind means the character or nature of the property must be the same, not the exact purpose, grade or quality. For example, you wouldn’t need to exchange an office building for another office building. You could trade this property for a shopping center, a ranch or another property of similar nature.
Other examples of like-kind exchanges include:
- A single-family rental home for an apartment building
- Raw land for an industrial property
- A shopping center for a condominium building
While the like-kind rule is more flexible than it seems, there are still limitations. Your personal residence does not qualify. Vacation homes or second homes also do not qualify if you do not hold them as rental properties in addition to their personal use. Properties you buy for flipping are disqualified from a 1031 exchange because you purchase them solely for resale.
For a 1031 exchange to qualify, the relinquished and replacement properties must both be used for investment, trade, or business intentions. This means a real estate investor cannot sell their apartment building complex and purchase a home they will use as their principal residence.
2. Identify Viable Properties
When an investor relinquishes their property for exchange, they initiate the 45-day identification window for a replacement property. Since this window is narrow, it’s best practice to have replacement property options in mind before you officially sell yours.
Property viability will hinge on the like-kind rule and the exchange value you make from the sale of your relinquished property. If you’ve already identified like-kind properties prior to opening the identification window, your main concern is value.
One of the requirements for a 1031 exchange is the equal or greater value rule. This rule requires the net market value and the equity of your replacement property to be equal to or greater than the net market value and equity of your relinquished property. The mortgage is also permissible alongside the value of the respective properties.
If your replacement property is lower in value, the remaining profit becomes boot. Boot also occurs when the mortgage on your replacement property is lower than the mortgage of your relinquished property. While the existence of boot does not disqualify you from the exchange, you will incur capital gains tax on boot values. Many investors perform 1031 exchanges with the intent of deferring capital gains tax entirely, so boot is not preferred.
When calculating the required exchange value for your replacement property, you should consider the costs you can pay with your exchange funds. Once you sell your property, you can use the earnings to pay for:
- Broker fees
- Qualified intermediaries
- Title insurance premiums
- Filing, finder and escrow fees
You can subtract these costs from the sale earnings to lower the required value of your replacement property. You cannot use your exchange funds to cover property taxes, financing fees, insurance premiums or repair and maintenance costs.
3. Meet Purchase Deadlines
Once you’ve identified your replacement property within the 45-day window, you’re ready to purchase. Section 1031 states investors have 180 days from the date of sale to complete the purchase of the replacement property.
The definition of purchasing a property is different in a 1031 exchange compared to the standard purchase of another investment property. In a 1031 exchange, money does not change hands from you to the seller — it passes through a qualified intermediary (QI).
A qualified intermediary is an independent person or entity that has no stake in your investments. A QI must agree to participate in an exchange transaction on behalf of the investor through a written document. When you relinquish your property for exchange, the QI holds the earnings until you’ve identified and purchased the replacement property. The money then passes from the QI to the seller of the replacement property.
It’s essential to note that the purchase window can be shorter if your income tax return for the previous year is due within the 180-day time frame. In these cases, you must purchase the replacement property by the tax return date. If you fail to complete the exchange by then, your earnings from your property sale will be subject to capital gains tax.
4. Buy the Replacement Property
You will have successfully purchased your replacement property when the money moves from your QI to the seller of the property. Another notable rule for a 1031 exchange is the matching name requirements. The name on the tax returns and the titles for the replacement and relinquished properties must be the same.
The only time this rule does not apply is when a single-member limited liability company is involved. If an individual is the sole member of an investment company, they may sell a property under their name and purchase the exchange property under their LLC name.
Once the sale is complete, you have a new property in your possession with deferred capital gains tax. This taxation is deferred indefinitely while you have ownership of the property. You can continue to defer capital gains tax if you complete another exchange with your replacement property.
Signs a 1031 Exchange Is the Right Capital Gains Tax Deferral Strategy for You
The significant selling point for a 1031 exchange is the capital tax deferral, but it’s not the only strategy for reducing these taxes. Practices like holding onto properties for more than a year or selling real estate when your income is low can also help you reduce capital gains taxes. How do you know if a 1031 exchange is right for you? There are a few considerations.
You Don’t Need Liquidity
Liquidity describes how easily an investment can be bought or sold without significantly affecting the value of the investment. The easier it is to sell an asset for cash, the more liquid it is. You may prefer liquid assets for the sense of security they provide.
Should you need cash for living expenses or emergencies, liquid assets are easier to sell. Generally, the more liquid an asset is, the less likely its value will increase with time. Some liquid assets may even decrease in value amidst inflation.
Assets like real estate have low liquidity or may even be referred to as illiquid. While you can still receive cash for assets like real estate, it’s much more challenging to value them and turn them into cash. Additionally, turning a quick sale on a property or flipping it without holding the asset for an extended period — generally more than two years — will cause a disqualification by the IRS for the exchange.
Committing to a 1031 exchange is right for you if you’re willing to accept illiquid assets. Even selling real property can take weeks or months, but with a 1031 exchange, you won’t earn cash directly from the sale. However, you can save in terms of capital gains tax, and your replacement property may offer significant earning potential through rent values.
You Have Time to Participate
Working with real estate investments in any capacity takes time. Even without a commitment to a 1031 exchange, you have to spend time searching for properties that meet your investment goals. With a 1031 exchange, there are more time considerations. You must work with a strict deadline window, but you also have to find properties that meet like-kind requirements.
While the capital gains tax deferral has appeal, a 1031 exchange is only a suitable arrangement if you have the time to dedicate to the process.
You Can Consult With an Expert
You can complete a 1031 exchange without expert guidance, but it may be challenging. It’s helpful to have an advisor or real estate professional to consult about potential properties and the best times to exchange a current property for a new one.
Partnering with an investment advisor typically comes with an additional expense, but these professionals can help you optimize your investments. They can also help you create a long-term investment strategy that reflects your goals. When you’re working with high-value assets, this expertise offers peace of mind.
View 1031 Exchange-Approved Properties at 1031 Crowdfunding
Capital gains taxes can be challenging when making high profits on real estate sales. A 1031 exchange is a viable method for deferring these taxes and potentially optimizing your profits. While this tax deferral method is appealing, it comes with its challenges.
At 1031 Crowdfunding, we streamline the 1031 exchange process with a substantial inventory of properties available for exchange. Joining our site gives you access to these properties to facilitate the identification and purchasing process. Many of our clients close on properties within a week.
Register at 1031 Crowdfunding today and benefit from our extensive property inventory and expertise for your next exchange.