The term 1031 exchange refers to Section 1031 of the U.S. Internal Revenue Code. This section allows a taxpayer to defer capital gains as well as related federal tax liabilities on certain property exchanges. This can be a powerful tool but one that many property investors don’t take advantage of. A prevalent reason for this is that the average real estate investor simply doesn’t know how it works, and with that in mind, we’re going to examine how does a 1031 exchange work in the usual scenarios.
What Is a 1031 Exchange in Plain Language?
In order to understand how does a 1031 exchange work, you need to understand what it is. In a broad sense, it’s a swapping of one investment asset for another. Most investment transfers are taxable, but if your swap fits the standards of a 1031, then you can offset the repayment period, reduce your tax obligations and, in some cases, even eliminate them. This is allowed because you are essentially maintaining the investment. You are changing its form, but you’re not seeing a capital gain.
How Often Is Such an Exchange Allowed?
The IRS doesn’t place a limit on how many times you can enjoy the advantages of such an exchange or how frequently you can enjoy those benefits. As long as the exchange meets the definition of a 1031, it’s an option that you can choose without penalties now or in the future. It’s not unusual for property managers in Boerne and other real estate investors to roll one property into the next over and over again. You can see then why this can be such a powerful investment tool when used wisely.
Can an Investor Capitalize on Each Swap?
Yes! Investors can capitalize on every 1031 exchange made, and this is where these swaps become a really attractive investment option. Most successful real estate flippers use this to their advantage. Let’s say you buy a house and then flip it three times that year. You can earn a profit on each sale, but any tax owed on the new properties is deferred along with the original purchase. That means that in an ideal scenario, you’re only paying tax once and just at the long-term capital gains rate of 15 percent. Note that each transfer has the potential for depreciation recapture, and if that occurs, it’s taxed as regular income. For this reason, 1031 exchanges are best performed by professionals who know the nuances.
No Personal Use Allowed
This IRS provision exists only for business investments. It applies to real estate purchased as an income property or for resale but it can apply to other kinds of business property too. You cannot, for instance, take advantage of a 1031 because you sell your current residence and purchase a new home. There are, however, opportunities to use a 1031 when it comes to vacation homes and the like. Ideally, you should have a leading property management company in Boerne property management at your disposal to help you manage and compartmentalize your investments and the various options available to you.
Properties Must Be Similar but Maybe Not Like You Think
The IRS provision uses the term like-kind to dictate what kinds of properties can be exchanged via 1031. This is an, unfortunately, vague term that leads to much confusion even among experts. The good news is that the rules are surprisingly flexible. This is a simplification, but what like-kind generally refers to is the intent with which the property is invested in. You could, for instance, exchange an apartment complex for a strip mall if the goal of improving the property and making it more valuable were the same.
Exchanges Don’t Have to Occur at the Moment of Sale
Purchasing real estate can be complex enough without having to worry about coordinating a sale on one hand and a purchase on the other. The good news is that the IRS doesn’t require that. In fact, the vast majority of 1031 exchanges are delayed, facilitated via three parties or in a form known as a Starker exchange. In the case of a typical delayed exchanged, an intermediary holds the cash from the sale until the purchase can be finalized. At which point, the intermediary transfers the money to the seller. There are some rules, such as having to designate a replacement property and having to close within six months. It’s also important to recognize that any cash received will be taxed as capital gains.
If you own just a single income property, then a 1031 exchange is an option that you may be able to take advantage of. It provides the means of improving your investment and income potential without incurring additional taxes that could prove cost-prohibitive. These exchanges are simple in concept but can be complex in execution. Therefore, it will usually be in your best interest to hire professionals well versed in such exchanges in order to protect your interests and position you for success.