Have you ever heard of a 1031 exchange? It’s not a term heard very often with residential purchases, but home investors do use a 1031 exchange as a way to move from one investment property to another. If you have ever thought about investing in an income property, that is a home you do not live in, then being aware of the benefits of a 1031 exchange is important.
What is a 1031 exchange?
A 1031 exchange, getting it’s name from the tax code section that outlines the use of this tool, is a way for investors to sell one property without having to pay capital gains taxes immediately by investing the profit from the sale into another investment property. In general terms, capital gains taxes are applied to the profits from properties that a seller owns for less than two years. Since an investor would purchase a home and want to improve it’s condition and sell quickly, the investor would be subject to a high capital gains tax. In order to defer this tax, investors can use a 1031 exchange.
How does a 1031 exchange work?
It does take some planning and preparation to use a 1031 exchange. First, the investor needs to find a property to exchange with the one the investor wants to sell. This property must be considered a “like-kind” property. This means that the property should be similar in nature and function to the one being sold. This means that you can’t exchange your personal home for one that is going to be a rental. However, this doesn’t imply that the home the investor wants to purchase has to be in the same condition as the one being sold.
The investor only has forty five days after the sale of the property to identify a new one to purchase. The investor also only has one hundred and eight days to close on the new property. If these deadlines are not met, then the investor is subject to capital gains taxes.
Next, the investor needs to find a qualified intermediary who can handle the paperwork involved with a 1031 exchange. The qualified intermediary is a person or company who will sell the property on the investor’s behalf, hold the profits in an escrow account, help purchase the new property, and transfer the deeds to the investor.
Finally, the investor files paperwork with the IRS.
Like anything related to taxes, the rules and regulations surrounding 1031 exchanges are subject to changes, so if you are interested in using this process it’s always best to talk to an expert.
Why do people use a 1031 exchange?
Home investors that are interested in building their portfolio of properties can utilize the 1031 exchange to help them purchase a new property. It’s best for people that want to continue to purchase investment properties. Since you cannot use a 1031 exchange on a personal property, you can’t use this method to avoid paying capital gains taxes on your personal home.
Home investors can still use a Realtor® like me to help them identify the next property to purchase. Your Realtor® will work with the home investor and the qualified intermediary to coordinate the sell and purchases of the properties.
