Real estate investors can find a surprising tool in the most unlikely of places: the Internal Revenue Code, specifically §1031. Within the 1031 exchange, you can reinvest your proceeds from your investment real estate sale into the purchase of another property. This eliminates or limits the tax you’d normally have to pay on those proceeds on your taxes that year.
The 1031 exchange is a powerful tool in the right investor’s hands, but it does come with some caveats. Keep reading for three essential things you need to know about the 1031.
There’s no such thing as a free lunch
A 1031 exchange defers tax, but it’s not eliminating that tax forever. According to the Internal Revenue Service, the tax on your gain from the sale is postponed if you’re using that money to reinvest into another “like-kind” property. You can keep doing these exchanges, however, and defer the tax indefinitely as long as you follow all the rules.
Keep an eye on the properties
The definition of “like-kind” property is a little broad, but real estate is usually considered like-kind to other real estate even if they’re not the same type, such as a multifamily home versus an apartment building. One thing to note here is that all of your cash proceeds have to be reinvested in the replacement property. If you sell an apartment complex for $500,000 and use $300,000 of that to buy a replacement multifamily home, you can still be taxed on the remaining $200,000 (minus the closing costs you’re allowed to deduct from the multifamily sale).
There are hard and fast deadlines
1031 exchanges have two timing rules. First, you have to put the replacement property you’re planning to buy in writing and deliver it to your qualified intermediary (QI) within 45 days of your property sale. The intermediary is the person or institution you gave the cash from the sale to hold; you’re not allowed to have that cash under the 1031 rules.
The next deadline is 180 days after your sale, which is all the time you have to close on the replacement property. Note that these two deadlines run concurrently, so if you give your QI the replacement property designation 50 days after the sale of the property, you have 130 days left to close on its replacement.
There are a lot of rules in 1031 exchanges, but the end result is well worth it! Make sure you work with qualified professionals so you don’t end up holding the tax bag at the end.
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