Most real estate investors who own investment properties are aware of the tax strategy known as 1031 exchanges. It allows investors to sell a property so that they are able to reinvest the money generated from the sale into purchasing another property. The tax strategy is common because you can defer the capital gain taxes from your old property to your new one.
Many have found this strategy beneficial, as it allows investors to grow their portfolio quickly and helps them build their net worth. Not only does it help investors to avoid paying taxes on ongoing investments, but it encourages them to actively reinvest.
Without like-kind exchanges (also called 1031 exchanges), many investors would struggle to find opportunities to increase their net worth and save taxes. If the strategy wasn't in place, property investors would be forced to pay capital gains tax once their property is sold, making it extremely difficult to reinvest due to a lack of funds.
When is a property eligible for a 1031 exchange?
If the property you are selling is of the same nature as the property you are looking to purchase, it is like-kind. For example, if you currently own an office and you are renting it out to tenants, you can exchange it for land, an apartment, or another office, even if it is larger and more expensive than the office you hope to sell.
If you are in the process of selling a relinquished property, keep in mind that you only have forty-five days from the date the property is sold to find a potential replacement property. The taxpayer will have to date and sign a form that will contain a description of the property that is being replaced.
Within the first forty-five days, it's possible for the exchanger to change the properties earlier identified with new properties. However, if the investor fails to deliver the identification by 12 am on the forty-fifth day, they can expect to be disqualified.
Most investors hire a team of financial experts to help them through the process. There are several companies throughout the United States dedicated to helping their clients with 1031 exchanges. For more details, check out https://www.peregrineprivatecapital.com/1031-exchange-facilitators-bend-oregon/.
What do you need to qualify?
The strategy was introduced in 1921. Not only does it allow you to defer federal capital gains tax on the property you are selling, but you can also defer the following:
- Net investment income tax.
- State ordinary income tax.
Those looking to benefit from the strategy must do the following:
- Buy a replacement property within one hundred and eighty days from the date their other property was sold. You will have to provide details on the date the sale was finalized.
- You can only purchase or sell a property that is considered to be 'like-kind'.
- By law, the entire process must be handled by a qualified intermediary.
- As mentioned earlier, the replacement property must be identified within forty-five days after the property was sold, even though investors have one-hundred eighty days to complete the sale.
Those who manage to successfully execute a like-kind exchange are able to defer the capital gains taxes by buying a new property with the proceeds generated from their old property. They can only buy a new property or a group of properties as long as the value of the new investment is equal to or worth more than the property just sold.
Eventually, when an investor decides to sell their investment properties outright, they will have to pay capital gains tax.
Without a 1031 exchange, diversifying your current investment property portfolio won't be easy. For example, if you currently own a rental property in a highly appreciated area, selling the property for another similar property won't make much sense. However, if you sell it, you could use the money to buy lots of other low-cost rental properties in an area where rentals are selling for less. If you go down this road, you could defer your capital gains tax and increase your cash flow due to having multiple properties for rent. This allows people to reach their investment goals because they don't have to pay taxes on new investments. Those who fail to execute a 1031 exchange strategy successfully often find it hard to invest in high-value properties.
Investors can do as many exchanges as they like, as there is no limit to the number of exchanges one person does. Over time, this can help investors create a real estate empire.
If you are looking to invest in properties located in different states throughout the country, keep in mind that 1031 exchanges are allowed anywhere in the US. This is great if you are hoping to purchase a property in a different state that has high potential growth.
If you currently own a commercial property and you are looking to enhance your cash flow, then you should speak to an expert about how this strategy can benefit you.
Management responsibilities can cause a lot of headaches for individual investors and investment companies, which is one of the reasons people look to sell a property. Updating the property, making sure the tenants are happy, and doing constant repairs can cause a lot of frustration amongst property owners, which is another reason a 1031 exchange is a good idea. Instead of keeping the property that is causing the landlord frustration, they can offload it and buy another property that doesn't require constant attention.
As discussed earlier, you must identify the new property within forty-five days. Due to this strict timeline, investors are advised to identify a potential property before the sale of their old property is completed. If you miss the deadline, you won't be able to implement the strategy. On top of this, the sale of the new property must be completed within one hundred and eighty days, which adds more pressure on the investor. Investors must be organized and ready to work fast to ensure everything works out.
Unfortunately, identifying 'like-kind' properties can prove challenging, especially when you only have a limited amount of time to identify the property and complete the sale. It's of vital importance that investors have a plan in place and the resources available to make the deal happen. Sometimes, investors who are desperate to take advantage of the tax strategy end up buying a property that doesn't suit their long-term investment goals, and regret their decision to sell their old property.
Trying to comply with all of the strict rules and regulations involved can prove frustrating. If you fail to comply with the rules in place, you might be forced to pay all of the capital gains taxes on the sale of your property. Some folks who have been penalized are forced to pay a penalty, which is why you should hire a reputable qualified intermediary to guide you through the entire process.
It's not tax-free
Some folks get confused during the process, as they think the strategy allows them to avoid paying tax. Investors must understand that a 1031 exchange allows the capital gains tax to be deferred, but it's not tax-free. If you think that tax liabilities will disappear once the sale is complete, think again!