1031 exchanges can be a useful tool for real estate investors because they allow the investor to defer paying capital gains tax on the sale of a property and potentially reinvest the proceeds into a more valuable or income-generating property. It’s important to note that there are strict rules and deadlines that must be followed in order to qualify for a 1031 exchange, and it’s always a good idea to seek the advice of a tax professional before pursuing one.
Did you know you can do a tax deferred “exchange” of one property into a larger property (or a piece of a larger property) such as an apartment complex? If you are thinking of selling an existing property and are interested in exploring a tax deferred exchange, please reach out – we may be able to help you place that capital tax deferred into one of our future apartment deals!
What is a 1031 Exchange?
A 1031 exchange, also known as a like-kind exchange, is a tax-deferred exchange of property that is used for business or investment purposes. It allows an investor to sell a property and defer paying capital gains tax on the sale by reinvesting the proceeds into a similar property.
To qualify for a 1031 exchange, the properties being exchanged must be “like-kind.” This means that they must be of a similar nature or character, even if they are not of the same exact kind. For example, a small rental property could be exchanged for a larger commercial property which could be an apartment building, industrial building, or other property used for commercial investment. The important piece is both properties are used for business and/or investment purposes.
In order to complete a 1031 exchange, a specific set of steps must be followed:
- Identify the property that you wish to sell (the “relinquished property”) and the property that you wish to acquire (the “replacement property”) within the required time frame. You typically have up to 180 days from the day you sell your initial property to the closing date on a replacement property.
- Use a qualified intermediary (QI) to facilitate the exchange. The QI holds the proceeds from the sale of the relinquished property and uses them to purchase the replacement property.
- Complete the sale of the relinquished property and the purchase of the replacement property within the required time frame.
- Meet all the requirements for a valid 1031 exchange, including the requirement to reinvest all of the proceeds from the sale of the relinquished property.
1031 exchanges can be a useful tool for real estate investors because they allow investors to defer paying capital gains tax on the sale of a property and to potentially reinvest the proceeds into a more valuable or income-generating property.
There are two important caveats to highlight for someone pursuing their first 1031 exchange so that they know what they are getting into:
1. On the plus side (although morbid to highlight), if you have continued to ladder up the value of your properties and defer the gains with multiple 1031 exchanges over time, then upon death, your heirs will receive the properties tax-free at the stepped up basis, making this an incredibly powerful tool to build generational wealth.
2. On the negative side, if you sell a future exchanged property and do not use a future 1031 exchange to continue to defer the capital gains, you may need to pay those combined deferred gains all at once. However, by deferring gains you may also have the growth of the properties to surpass any taxes due which may be viewed as still directionally accurate in building wealth.
