There are several types of real estate investments. A real estate investment can include a house, a townhouse, a condominium, vacant land, a strip mall, a hotel or an apartment building, as long as it is not your primary residence.
Tax benefits are considered to be one of the best benefits of real estate investing. To defer capital gains taxes, investors can complete a 1031 exchange by buying and selling like-kind properties. In addition to appreciation and rental income, real estate can also produce passive income.
Capital gains tax could be imposed on profits when a property is sold. Investment property owners can defer capital gains tax on their property sales thanks to Section 1031 of the Internal Revenue Code.
Although this tax law has many advantages, it can be difficult to understand. The confusion can be caused by different rules and regulations pertaining to 1031 exchanges. In order to avoid generating a taxable event, investment property owners must follow strict rules and meet deadlines.
1031 Exchange: What Is It?
A 1031 exchange involves the exchange of one real estate property for another. As a 1031 exchange, you can defer tax on the exchange, despite the fact that it would typically be taxable as a sale. Using this type of rollover, you can transfer the gain from the sale of your property to your new home, allowing you to postpone your taxes.
Regulations and Rules for 1031 Exchanges
The IRS defines a rigid structure for 1031 exchanges. Your exchange may be disqualified from tax deferral benefits if it does not meet the regulations.
1031 exchanges require like-kind properties. The investor does not have to recognize a gain or loss in a like-kind exchange because he or she exchanges a business or investment property for another business or investment property. Like-kind properties have the same nature or character but differ in quality or grade. If you renovate an apartment building, you can exchange it for an unimproved strip mall, for example. Like-kind properties are the most common type of real estate.
According to the Tax Cuts and Jobs Act of 2017, assets such as equipment, aircraft, and franchise licenses can’t be exchanged in a 1031 exchange. Real estate investments and businesses are the only properties eligible for 1031 tax benefits.
A United States property must be attached to both properties. It is not possible to apply Section 1031 regulations to international assets, and one property in the United States is not considered property in another country.
1031 exchanges can be completed as often as you wish. If you sell the investment property and receive cash or pass it on to your heirs, you can defer paying taxes until you ultimately sell the asset and receive a step-up on a basis.
1031 Exchange Example
Although 1031 exchanges can be complicated, capital gains rollovers and potential tax savings can be beneficial to real estate investors. For a better understanding of this process, consider the following example:
Taxes are payable on the $400,000 profit if the property was purchased for $100,000 and then sold for $500,000, resulting in a loss of nearly $120,000.
A 1031 exchange versus a standard sale is illustrated in the following table. Using a 30% tax rate, we have included capital gains, net investment income tax, and depreciation recapture. You may have different tax brackets, states, how long you’ve owned the property and other factors than this figure. The example also excludes expenses associated with sales and capital improvements.
Typical property sales include:
$50000 in net proceeds
$120,000 in taxes is due
A total of $380,000 was reinvested
Tax deferral and capital growth are both possible with a 1031 exchange:
A total of $500,000 was received as net proceeds
Taxes due: $0
Reinvestment capital: $500,000
1031 exchanges allow you to buy one or more new properties for $500,000, and you will not owe any capital gains taxes on the sale. New investment properties are funded with the sale proceeds, which could generate cash flow and appreciation.
Real estate investors can create more wealth with these 1031 exchanges. It may be possible for real estate investors to profit from 1031 exchanges by buying more lucrative properties.