Tanya Vincent April 20, 2023
So you have an investment property that isn’t quite pulling its weight… What should you do? 1031 it! Let us introduce you to the often-missed, golden opportunity in real estate, that could help you increase your investment while avoiding unnecessary taxes.
In a 1031 Exchange, you are essentially swapping one investment property for another. Typically, selling a property would be considered a taxable event, but in this case, if your property meets the requirements for a 1031 Exchange, you are deferring those capital gains on the sale and delaying a major tax penalty while keeping and even growing your investment. And the beauty of it all? There is no limit on how many 1031 exchanges you can do so you can keep cultivating your investment and growing your equity over time. If done correctly, you would only have to pay a long-term capital gains tax once – when you decide to cash out on your investment for good.
We know what you’re thinking – this is too good to be true. But in fact, it’s quite attainable if you follow the rules, and those rules can be quite forgiving. Let’s walk through them:
The first requirement for a 1031 Exchange is that you must swap one property for a similar one, and both properties involved must be for business or investment purposes. For example, you can’t swap a primary residence for an investment property (unless you rent out that primary home for some time first).
Unless you can line up an immediate swap (you find someone with the exact property you want who also wants the exact property you have), you’ll likely be doing a delayed exchange. In order to avoid those capital gains, a 3rd party qualified intermediary will “hold” the cash from the sale of your property until there is a replacement property to put that cash into. You then have 45 days to designate the replacement property to the intermediary. Additionally, and in parallel, you have 180 days to close on the replacement property from the day you sell your initial property.
If you’ve found a replacement property and want to act quickly, you can also 1031 it after purchase, as long as you still fall into the 45 and 180 day rules mentioned above. Reverse exchanges tend to cost more in the exchange company fees and are generally not as common due to complexity.
Moving into a swapped 1031
Say you performed a 1031 exchange on a property and now want to move in yourself. Not so fast. To stick to the 1031 rules, you will have to continue renting out and keep it as an investment property for at least 12 to 24 months. After those first couple of years you could consider moving in and making it your primary residence. Furthermore, you have to hold this property for at least 5 years and use it for at least 2 of them as your principal residence to sell it as such.
If your property is inherited by your heirs after your death, they do not have to pay the tax you deferred and will receive that property at its market-rate value. So it’s a great way to plan for generational wealth.
Exchanging primary and secondary homes
Ultimately, you have to rent out primary and secondary residences for a certain period before they can qualify for a 1031 Exchange.
Be careful if you’re planning to change ownership on a 1031 property. The IRS wants to see that you did the exchange with the objective of investing and may disqualify it if you change ownership right away.
How do you report a 1031 Exchange to the IRS? You’ll need to submit Form 8824 along with your tax return for the year during which you did the exchange. Make sure to provide descriptions and values of both properties, dates when they were identified and transferred, and if you have any relationship with the person that owned the exchange property. Additionally, don’t forget to disclose the adjusted basis of the property given up and any liabilities/debts that you adopted or forgoed. You might also consider working with a 1031 Exchange company who is practiced in the nuances and rules of a 1031 (we recommend The 1031 Investor). With property swaps like this, it’s better to have all your ducks in a row, since the penalties of filing incorrectly could be major.
As long as you color within the IRS lines, your average investment property can become the golden nest egg you want it to be. And despite the rules of a 1031, the investment possibilities are certainly worth the effort!
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