By using a 1031 exchange, you could theoretically defer paying capital gains tax on the sale of an investment property forever.
While this understandably gets a lot of investors' attention, it's not quite as simple as it may sound. 1031 exchanges come with specific rules that you have to follow in order for it to be a valid strategy.
If you're interested in using this strategy, this post is for you. Here we'll go over what a 1031 exchange is and some of the most important rules you'll need to follow.
Keep reading to learn more.
What Is a 1031 Exchange
A 1031 exchange allows you to sell an investment or business property in order to buy another, similar one. By setting it up as a 1031 exchange, you're able to defer the capital gains tax on the sale of the original property.
This comes from section 1031 of the Internal Revenue Code and is also sometimes called a like-kind exchange or a Starker exchange.
This is an excellent strategy for seasoned investors, but new investors should also keep it in mind as they develop their investing plans.
As mentioned, there are some strict rules for you to follow for it to be considered a valid 1031 exchange.
Like-Kind Properties
These exchanges need to be made with two properties that are considered to be like-kind.
To count as like-kind, the new property must be similar to the original in purpose. For example, you can't sell a rental property and exchange it for a vacation home. That would not be considered like-kind.
The new property also has to be of equal or greater value to the property you're selling. When comparing the value of the properties be sure to take any debt or leverage into account. If overall you wind up with less liability, it can then be taxed.
Qualified Intermediary
When you sell your property, the money from the sale must go to a qualified intermediary. This person will hold the money in escrow for you before it is then put toward the new purchase.
If the money were to go to you instead, you would no longer be able to do a 1031 exchange.
Timing
The 45-day rule says that within 45 days after the sale of your property, you'll have to choose the replacement property. You'll then have to let the intermediary know in writing.
The 180-day rule says that you must close on your new property within 180 days of the sale of your old property.
It's important to note that both timers begin with the sale of your property. The 180 days don't start after choosing the replacement property.
Informing the IRS
After everything is complete, you'll fill out an IRS Form 8824 that you'll file with your tax returns. In this form, you'll need to describe both properties and give a full breakdown of the timeline, people, and money involved.
Build Wealth With a 1031 Exchange
A 1031 exchange is an excellent way to grow your real estate portfolio and your overall wealth. Before attempting an exchange like this, be sure you understand how it works and what you'll have to do.
A 1031 exchange isn't the only way to enjoy tax benefits when investing in real estate. Check out our article on some of the other tax benefits real estate investors can expect from owning a rental property.
