Want to Defer or Even Eliminate Real Estate Taxes?
With real the real estate market at an all-time high, we are going to go over 1031 exchanges, which can help you defer or even eliminate real estate taxes.
Simply put, a 1031 exchange is a swap of one investment property for another that allows capital gains taxes to be deferred. The term gets its name from IRS code Section 1031.
But – and this is important – you have to begin this process, and the 1031 must be in place before sell the investment property.
Then, from that closing date, the person selling the investment property has 45 days to identify the replacement property to buy and has 180 days to close on the new property.
To obtain 100% tax-deferral, the exchanger needs to reinvest all the net proceeds from the sale and replace any debt paid off with either new debt or new cash. Most exchangers buy a property of equal or greater value than the old property. These are often called “like kind” exchanges.
Remember, exchanges are very flexible. An exchanger can sell any type of real estate used in a trade or business or for investment and replace it with any type of property used in a trade or business or for investment. You can sell residential property and buy commercial property. You can sell an office building and buy a shopping mall. The rules are very flexible.
Let’s say that you bought a property for $400,000 15 years ago, and now it’s worth $700,000. Some people might think you only have to pay taxes on the $300,000 gain, but that isn’t the case if you depreciated the property.
Special rules apply when a depreciable property is exchanged. It can trigger a profit known as depreciation recapture, which means you may have to pay ordinary income tax on it! In this case, that would be about $218,000 in depreciation, making your cost basis about $182,000. If the property was sold for $700,000 then you’d have to pay personal income taxes on $218,000 and a capital gain tax on 300,000!
The way that gets applied depends on your personal tax rate and some other factors. But, the 1031 exchange defers all of that tax into the new property.
The key to these is that The IRS requires the use of a Qualified Intermediary (QI) to hold the money from the time of the sale until the new purchase. The QI actually becomes the principal in the transaction and is assigned into the relinquished property contract as the seller and then is assigned into the replacement property as the buyer. This lets the IRS see the investor as never being out of their investment so that taxes can be deferred into the new purchase. They also provide the exchange documents for a valid exchange.
Properly using a 1031 exchange can be extremely complex but help delay or avoid a significant amount of tax when it comes to real estate.
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