1031 Exchange for dummies: An easy-to-understand guide
Real estate investors are flocking to Arizona to purchase properties. There are plenty of opportunities to invest in this market, and Phoenix was named the top market for real estate investors in 2019.
You want to take advantage of that market, but what are your options when you’re ready to cash out? You can leverage a 1031 exchange.
Do you want to know what a 1031 exchange is and how it can help you keep your profits?
Read this 1031 exchange for dummies guide to find out.
What is a 1031 Exchange?
One of the first things you learn as a real estate investor is that you want to make as much profit and minimize your tax liabilities as much as possible.
When you invest in a real estate property, you can earn income from rent, or flip a property. When you’re ready to sell, you list the property for more than you paid for it.
That’s your profit or capital gains. The IRS will take a percentage of those capital gains when tax time arrives. The amount you owe will depend on how much you made in capital gains.
Capital gains can apply to other types of investments, too. Profits from stocks, mutual funds, and commodities trading are all considered capital gains.
In real estate investing, there is a way to defer the taxes paid on capital gains. That’s called a 1031 exchange. It’s named after the section of the IRS code that refers to this deferment. Can you guess what section that is? If you guessed section 1031, you’re correct.
1031 Exchange for Dummies
A 1031 exchange is actually pretty complex. There are a lot of rules and deadlines that you need to know about in order to qualify for a 1031 exchange tax deferment.
The first thing you need to know is what type of transaction qualifies. You can defer taxes for what the IRS considers to be “like-kind” exchanges. That applies to investment or business properties that you swap for other properties.
There is a lot of leeway as to what the IRS considers like-kind. You can sell a duplex and purchase a small apartment building. The property has to be used for business or investment purposes. Residential properties do not qualify.
Investors who flip residential homes are unable to reap the benefits of deferred taxes. That’s because the IRS code specifies that properties held for sale do not qualify, which applies to house flipping.
A property that has an investment or business purpose, such as collecting rent or using a property to be a warehouse, does qualify for 1031.
With a 1031 exchange, you’re essentially rolling your proceeds from the sale into your new investment property.
If you’re not sure a 1031 exchange is right for you, you should consider alternative to 1031 exchange.
Don’t Mistake What Deferred Taxes Means
As a beginner investor, you probably think that a 1031 exchange is a good deal. You don’t have to pay capital gains taxes and get a new property in the process.
Your taxes aren’t deferred indefinitely. You will have to pay capital gains taxes if you sell your new property and keep the proceeds instead of getting another property.
If you choose to keep your replacement property and you get income from that property, it makes sense to keep it and continue to defer the taxes.
Hire a Qualified Intermediary
You can’t do a 1031 exchange on your own. You need someone who can guide you through the process of the exchange. You also need someone to hold onto your funds while you’re buying a new property.
That’s what a qualified intermediary does. They are kind of like escrow officers. When you sell the first property, the money goes right to the qualified intermediary. You don’t see nor touch the funds.
That’s because when you handle the proceeds of the sale, that counts as income. You’ll be responsible to pay taxes on that sale.
You are required by law in most cases to have a qualified intermediary.
Know the Deadlines
There’s a tricky dance that revolves around 1031 exchanges. There are a number of deadlines that you need to know and abide by. If you miss a deadline by a minute, your 1031 exchange is terminated, and you have to pay capital gains taxes.
You need to get to work as soon as you sell your property. You have 45 calendar days (not business days) to find a new property. You could also decide to have several replacement properties instead of one.
You have to identify your new property and provide written intent to the IRS. You need to give specifics of the new property, such as a legal description of the property.
Now that you have one or more properties identified, you have 180 calendar days from the close of the sale of your former property to complete the purchase of the new property.
Use 1031 Exchanges
The difference between successful and struggling investors is that successful investors know all of the financial tools available to them. Successful real estate investors use 1031 exchanges to defer capital gains taxes while investing in another and potentially more profitable property.
For beginning investors, this 1031 exchange for dummies guide is meant to give you a basic overview. You know what kind of options you have available to defer your taxes and limit your tax liability.
When you’re dealing with profits of $10,000 or more, that can turn into major savings. It also improves your profitability.
Do you want more great real estate tips? Come back to this website often to find out the latest happenings in the real estate market.