When Using 1031 Exchange to Avoid Taxes

When Using 1031 Exchange to Avoid Taxes


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When Using 1031 Exchange to Avoid Taxes

When using 1031 Exchange to avoid taxes, remember there are only two certainties: Death and Taxes. I suspect you never avoid taxes. The only way I see to avoid taxes is not to invest.

What is a 1031 Exchange? A 1031 exchange is mostly relevant for people with rental property. The 1031 exchange is for real estate investors who want to use the proceeds from the sale of one rental property to purchase another rental property and defer capital gains taxes. Defer not avoid.

Why Would I Use a 1031 Exchange?

The purpose of a 1031 exchange is to defer paying 15 percent taxes on capital gains. If you sell a property and you’ve made some money on it, you pay 15 percent on your gains. If you defer your taxes by using a 1031 exchange, you don’t have to pay the IRS as long as you roll that money into another investment (rental) property

Keep in mind, the taxes you defer paying could be as high as 30 percent when you consider depreciation costs, etc. On the surface, it’s the 15 percent capital gains tax you are avoiding or defering here.

Using a 1031 Exchange

Erin Spradlin at BiggerPockets.com shares eight rules for using the 1031 Exchanges.
  1. The rule works for like-kind properties.  The properties in question must be used for business or as an investment. This means the rule excludes primary residences, which are for personal use the majority of the time. Like-kind property also must be within the United States to qualify. For example, a seller cannot use the proceeds from selling a hotel in the U.S. to buy a hotel in London and expect to defer capital gains on the sale. Securities, stocks, partnership interests, and other financial assets are excluded from the definition of like-kind property.
  2. From the day you sell your initial rental property, you have 45 days to find a property you wish to purchase
  3. From the day you sell your initial rental property, you have 180 days to close on a new property.
  4. You must purchase property of equal or greater value than the adjusted value (not the price value — but the adjusted cost basis when taking into account depreciation less commissions and closing costs) of the property you sold, or you will be taxed on the difference.
  5. Warning: If you do not close on a property within 180 days of selling your initial property, you pay the capital gains tax on your initial property.
  6. During the interim of selling your first place and closing on your second, you cannot touch/look at/get close to the profits from the first place you sold. That money stays with a 1031 exchange facilitator (qualified intermediary) and not, not, not with you.
  7. The old property and the new property must be sold and bought by the same entity. Meaning, if you sell a property as John Smith, you have to buy the new one as John Smith — and not as Smith, LLC.
  8. Experts can debate this point, but a good rule of thumb for the majority of you is this: You must own your property for one year and one day to make this 1031 exchange. Otherwise, The IRS will penalize you.
  9. There is no limit how many times you can roll a transaction forward, avoiding paying capital gains. Eventually, the end will come, and you will pay your taxes.

These are the basics of a 1031 exchange. If you have more questions, reach out to a 1031 facilitator, a trusted tax professional, or someone you know and respect in real estate.

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