1031 exchanges offer people the opportunity to invest in real estate without paying capital gains taxes on the property when they sell these properties and purchase new properties. This can save an investor a great deal of money and the properties eventually can become a primary residence, which has no capital gains on a substantial profit.
How the Program Works
An investor purchases a property for investment purposes; this could be a rental home, a rehab project, a commercial building, or vacant land. While the owner holds the property the government allows them to claim depreciation over 27.5 years, this is an interest free loan from the government. However, when the owner sells the property and takes the cash in profit, they pay taxes on the profit plus the amount of savings they had in depreciation, a rate of up to 25%.
During a 1031 exchange the owner sells the property and never takes possession of the cash, instead they invest it into a new property, never paying taxes on the profit or depreciation they claimed while owning the previous property. This allows the investor to purchase a better property and continue to increase their wealth because they have more money to put into the new property.
Rules of Exchanging Property
While this program is a great benefit to investors, it does have certain rules that investors must adhere to diligently in order to prevent paying the taxes on any gain.
The profit and gain must remain in the hands of a qualified third party, usually a lawyer or title company handling the closing of the sale and purchase of the property. This means that the investor may never actually take possession of the cash. If the investor closed at one company and then moved the cash to a different title company for the purchase of the new property, they would need to pay tax on the gain.
Once the investor closes on the sale of the first property and the money is in control of a third party the investor has 45 days to find a new property and 180 days to close on the purchase of the new property.
The new property must be of equal or greater value to the property the investor sold. This eliminates an investor from highly leveraging properties and using the profits to purchase properties of lesser value. The debt amount on a new property must also be equal or greater to that of the previous property. This is to prevent an investor from purchasing property and using the sale and profits to reduce leveraged amounts on new properties.
Eliminating Taxes on the Final Sale
While most investors may want to eventually realize their profits and end the investment they have made in real estate, this is where the program becomes more difficult.
Homeowners do not need to pay taxes on the gains of their primary residence provided the gain does not exceed $250,000 for an individual and $500,000 for a married couple. However, to qualify for this exemption a person must live in a property for two of the last five years.
To convert a 1031 exchange property to a primary residence the investor must own the property for a minimum of five years and have lived in the property for the last two years.
While I am not a tax professional, and therefore unqualified to offer the best tax advice, my previous career as a mortgage broker and a licensed real estate broker fully acquainted me with this program. I dealt with several transactions where the investor used this program and only one where they did not; they received bad advice from their real estate salesperson. Any tax questions you may have regarding this program you should direct to a qualified tax professional.
Whenever you use this program to buy or sell real estate you should use a trusted real estate professional and closing agents that fully understand the program and preferably ones that have conducted these transactions in the past.
While not every property or transaction may qualify for the exchange program, using it whenever possible can save a substantial amount of money on the purchase and sale of investment real estate.
For more information visit www.1031.org