When a real estate investor decides to sell a property, capital gains taxes can eat into the earnings. However, if you use the appropriate method while investing in real estate, an investor can avoid paying taxes on capital gains. A 1031 Exchange is one of these strategies, which allows real estate investors to swap one investment property for another.
Any capital gains from selling the first investment property would not be taxed if the money was invested in another investment property. If you’re considering doing a 1031 Exchange for a rental property, then you should be aware of certain basic standards and principles before getting started.
Key Takeaways
- A 1031 exchange allows investors to defer the capital gains taxes on their sales proceeds when selling an investment property.
- 1031 exchange rules and timelines must be kept in mind to successfully defer the capital gains taxes.
- The 1031 exchange timeline requires the investors to identify replacement properties within 45 days of selling an investment property and closing on them within 180 days of selling an investment property.
What Is a 1031 Exchange?
A 1031 Exchange includes exchanging one investment property for another similar type. Any capital gains you make on selling your first home can be deferred, allowing you to avoid paying capital gains taxes. Without involving in a 1031 Exchange, you would be required to pay taxes immediately following the sale. When investors want to sell or renovate their current property, they frequently use the 1031 Exchange method.
1031 Exchange Rules and Timelines
When you wish to exchange your one investment property for another, finding someone who wants to buy the home you’re selling while also possessing the property you desire is challenging. Because of this difficulty, most exchanges are delayed.Delayed exchanges include a Qualified Intermediary (QI) who then holds the money you receive from selling your property and eventually utilizes the money to acquire the replacement property. This type of exchange is known as a swap. When performing a 1031 Exchange, you must adhere to two unique rules: the 45-day rule and the 180-day rule.
45-Day Rule
This rule involves the identification of the replacement property. When you sell your first home, the proceeds received from the sale are paid to the intermediary. If you receive the cash in your hand, you will not be able to take advantage of the 1031 Exchange tax benefits.You must designate the replacement property to your intermediary within 45 days of the sale of this property. As long as you eventually buy one of them, you can designate up to three properties as potential replacement properties.
180-Day Rule
The 180-day rule requires investors to close on their replacement property within 180 days after selling the old property, which is another guideline every investor must follow when completing a 1031 Exchange. This time period does not begin when you designate your replacement property; if you wait 45 days to select a new property, you will only have 135 days to close.
Warning The 45-day and 180-day timeline runs concurrently. Meaning, investors get a total of 180 days to do a 1031 exchange. They must identify replacement properties within 45 days of selling an investment property and close on them either within 180 days of selling an investment property or within 135 days of the end of the 45-Day ID period.Reverse Exchange
You could also do a reverse exchange, which allows you to buy a replacement property before you sell your old property. Remember that the 45-day and 180-day time frames still apply.
Potential Tax Implications
If you have any cash left over after purchasing the new property, you will receive it after 180 days. The remainder of the profit is taxed as capital gains. It is also critical that you consider your financing. If your former property’s mortgage was $600,000, but your new property’s mortgage was only $500,000, the difference between the two properties will be considered a gain. The profit in this scenario is $100,000.It is possible to exchange one rental property for another if you follow the above mentioned conditions. A mistake made during this process could disqualify you from doing a 1031 Exchange, resulting in the taxation of any capital gains.