Paying taxes on capital gains for property transactions has always been a hindrance to those involved in real estate investment. Why should investors pay taxes on profit from real estate transactions if they’re putting the profit right back into some other real estate transaction?
The answer: They shouldn’t.
That’s exactly why the IRS created 1031 exchanges: to allow for tax deferment on profit that is reinvested immediately. Notice it’s a deferment, not a credit or a reduction. It does have to be paid eventually, just not at the time of sale and not until the money is taken out of the property, at which point it is taxable. Eager to learn more, I found some info on 1031 exchanges at 1031.org.
What Is a 1031 Exchange?
Simply put, a 1031 exchange is a method of deferring the tax on capital gains until some point in the future, according to 1031.org. They’re called Section 1031 exchanges because Section 1031 of the Internal Revenue Code states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.”
Section 1031 was created to encourage reinvestment of sale proceeds of property into similar property. Obviously this stimulates business and growth. As long as the investor continues to put profit back into more property, taxes are not owed.
This all makes pretty good sense. Let’s say I invest in a house in Detroit that costs me $100,000. I put $50,000 into the house and put it on the market. It sells for $250,000. My $100,000 profit, or capital gain, is then put into another property that I buy to fix up and sell. This continues, and all of my capital gains are deferred with a 1031 exchange UNTIL I sell my last property and enjoy my profit. At that point, I pay all taxes owed.
Frequently Asked Questions About 1031 Exchanges
Here are some of the most common FAQs regarding 1031 exchanges.
What is the benefit of a 1031 exchange versus just selling property?
A Section 1031 exchange is one of the few ways investors can defer taxes due on the sale of property (assuming it qualifies for a 1031 exchange). Deferring taxes allows investors access to the money that would otherwise be paid in taxes, allowing them to invest in another property.
What are the general guidelines to follow in order to defer all the taxable gain?
The IRS is very clear on this. The value, equity in and debt on the new property must be equal to or greater than the value of the property being sold for an exchange to be valid. This is even more important – ALL of the profit from the property sale MUST be used to buy the new property. If even a tiny percentage of the profit is used for something else, the 1031 exchange is not valid
If there is already a contract to sell the property, is it too late to start a tax-deferred exchange?
No, as long as there has not been a transfer of title or a closing on the sale of the property, a tax-deferred exchange can still be arranged. Once the closing occurs, it is too late.
Can the replacement property eventually become the investor’s primary residence or vacation home?
Yes, but Section 1031 has holding requirements (minimum length of time the new property must be owned) that must be met prior to changing the primary use of the property. According to 1031.org, the IRS has no specific regulations on holding periods (though a minimum of a year is recommended), and “if the owner later on wants to take advantage of the home owner’s exemption (up to $250,000 or $500,000 for a couple), there is now a five year holding period requirement.”
Let us know if you have any questions by leaving us a comment below. We’ll do our best to get you an answer. But PLEASE remember to consult with a professional tax advisor when doing anything related to taxes or the IRS. Don’t listen to anyone other than a pro. It could cause you some serious problems, no?
Finally, remember that if you’re a real estate investor or considering becoming one, now is still a great time to do so. Mortgage rates are still very low and property values, though trending up, are also still very low in many parts of the country. As always, please let us know if you have any questions. We’re here to answer them. Happy investing!