What is a 1031 exchange?
Simply put, a 1031 exchange is a key tax-deferral strategy for real estate investors when buying and selling investment properties.
If you own a residential property and rent it out as an investment, then you may be surprised to face a tax bill when you sell it. Your gain from the sale and the amount of automatic depreciation deductions you received for the rental property are taxable if not properly reinvested.
Instead of instantly owing taxes on gains realized from the sale, you can reinvest the sale proceeds into a qualifying property as an exchange. Your tax liability is deferred so long as potential profits are continuously reinvested.
Admittedly, a 1031 exchange seems like an obscure tax concept at first. However, any investor can quickly gain a basic understanding of the tax advantages and eligible investments for 1031 like-kind exchanges.
A 1031 exchange is readily available for many types of potential real estate investments
You still have plenty of flexibility to customize your investment strategy within a 1031 exchange. The qualifying property requirements of like-kind nature and character are less narrow than you might assume. For instance, real property in the U.S. can be like-kind whether improved or unimproved.
Don’t get caught up in finding a specific sale price for a new investment property
Sometimes, the new investment property is bought for less than the investment property sale price. You still have options to re-invest those surplus sale proceeds through the property improvement 1031 exchange tax shelter.
Reinvesting the tax-deferred gains is an alternative to financing the improvements with construction business loans and quickly increases the new property value.
What are the qualifications for using a 1031 exchange?
To be an eligible 1031 exchange investor, you need to own investment or business property individually or as an entity. The new property must also be purchased for investment or to conduct business.
You can either instantaneously swap one investment sale for a new property purchase or defer the reinvestment within IRS deadlines. However, you absolutely cannot sell off a new (and maybe improved) property as a flip sale instead of a rental investment.
Failing to meet the 1031 exchange qualifications means converting property sale proceeds to an instant and unfortunate tax payment on the boot as capital gains. That’s a tough pill to swallow when you consider that the sale profit would otherwise be deployed as investment capital through a properly structured 1031 like-kind exchange.
Contact the right professionals
Successfully and maybe indefinitely deferring taxes on investment property sales requires that after selecting eligible properties, you also make sure that you are within the IRS required timelines for all qualifying properties, maximizing the tax savings benefit by fully reinvesting all surplus sale proceeds and filing all required IRS, legal and property ownership records documentation.
Saving a relatively small chunk of cash at closing over realtor fees and commissions is generally not worth losing quality advice on how to maximize the overall value of your investment property exchange.
Again, remember, the real estate properties are among many different yet equally important moving parts of the complete 1031 exchange transactions.
In addition to an experienced realtor, you’ll want to consult with knowledgeable tax, accounting and required qualified intermediary professionals.
Plan both the original sale and next property purchase
Selling the original investment property is only the first portion of the 1031 exchange process. You must ensure that all sale proceeds are properly held in an escrow account through the required qualified intermediary before reinvesting in the purchase of the replacement investment property.
Be a proactive investor in urgently identifying the next investment property well within the IRS guidelines. You can choose among several different real estate investment scenarios for new property investment options, but you must complete the transaction to reinvest the proceeds before the IRS deadlines.
Clarify your expectations before the closing so there aren’t any gaps. Be sure that you are clear on the qualified intermediary’s scope of services as professional providers’ levels of involvement vary in completing the full investment property exchange.
Especially for newer investors in these types of real estate properties or for complex investment property exchanges, contacting one of the best 1031 exchange companies can line up the necessary experts to streamline the full transaction.
Where to turn to next for your real estate investment strategy
Real estate is one of the best investing strategies, and 1031 exchanges offer valuable tax incentives as investment property tax vehicles. Fortunately, they are very accessible and valuable to even a small-scale or single-property real estate investor.
You now have knowledge of the potential benefits of a 1031 exchange. The major takeaway for enjoying tax-deferred gains from your next real estate investment property sale is timely and complete compliance with all Section 1031 IRS qualifications.
As such, don’t take any IRS qualification deadlines for granted. While essential, closing on the replacement property can become an afterthought unintentionally, especially when deferred. Schedule a grace period before the 45-day purchase property identification deadline as well as the 180-day purchase deadline to be sure that you are not stuck with a premature tax bill.
Planning all important aspects as early as possible with reliable professional guidance is the best way that you can avoid an unnecessary and (even worse) expensive tax bill from your next real estate investment property sale.