- When you sell a property, a so-called ‘1031 transfer’ can save you hundreds of thousands of dollars in deference on capital gains tax.
- But to qualify, you have to use the proceeds to buy another, certain kind of property.
- With the right timeline and ‘like-kind’ properties, investors can revamp their strategy to maximize profits without Uncle Sam taking up to 20%.
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In most property transactions, taxes are a sure thing. But there’s one way you can avoid a big tax hit from the IRS the next time you sell a property. The only catch is you have to buy something else first.
It has to do with the so-called 1031 exchange, named for a specific section of the IRS code. Sometimes called a “like-kind exchange,” the provision gives investors the ability to defer capital gains taxes from the sale of an investment or business use property, as long as a like-kind asset is purchased with the sale’s profits.
Put more simply, the 1031 allows you to make smart property investments without owing a massive bill to the IRS.
The exchange is a great strategy for investors looking to swap one asset for another, or for any investors interested in avoiding a capital gains tax of, depending on your bracket, up to 20%.
What that means for an investor is often hundreds of thousands in immediate tax savings, and a chance to redirect an investment strategy to maximize profitability.
A high-maintenance rental in an expensive city like New York, for example, could be exchanged for a series of lower-maintenance investment properties in more savings-friendly states with lower costs of living.
RULES TO KEEP IN MIND
Strict rules dictate 1031 eligibility having to do with the timing of sales and purchases, as well as the types of properties that qualify for use. While these are important to keep in mind throughout the exchange process, consulting a lawyer and understanding all the IRS fine print is a critical step towards making the most of your tax benefits and keeping up to date with IRS regulations.
Here’s a few of the main things to consider.
The 1031 doesn’t apply to personal property.
The exchange only applies to business or investment assets, not personal homes. In other words, you can’t use a 1031 to sell your condo and move to a single-family home.
The exchange must be performed along a narrow timeline.
After the sale of the first property, a replacement property must be identified within 45 days of the original sale or the exchange is forfeited and the transaction becomes subject to capital gains.
After the 45 day identification window, 135 days are left to close on the new replacement property or properties.
Altogether, this means the investor has about a month and a half to identify their new property, and about six months to close.
Both properties must be “like-kind” to qualify.
“Like-kind” properties, according to the IRS, are simply ones of similar nature or character, without consideration of quality. For example, the sale of a multi-family apartment complex in New York for a similar multiplex in North Carolina would be acceptable.
Market values and titles must match.
Names on tax returns and titles for both properties must match. The net market value of the newly purchased property must meet or exceed the value of the property being sold as well.
Both properties need to be in the US.
For a successful exchange, the IRS mandates any properties involved in the transaction be located within the US.