What Exactly Is A 1031 Exchange In Real Estate?
A 1031 exchange is a tax-deferred transaction. It is found in Section 1031 of the IRS code, and it’s commonly referred to as a 1031 exchange. It is a tax-deferred exchange that allows someone selling investment real estate to sell, purchase a replacement property, and defer any taxable gain or capital gain tax that is due after the sale of the replacement property.
Who Uses The 1031 Exchanges?
Individuals who have an interest in increasing their wealth through real estate investing uses the 1031 exchange. Real estate investors and people who own real estate property for additional income, such as a married couple who owns a multi-family home that exceed the allowable $500,000 exemption under federal law, can benefit from a 1031 exchange.
What Are The Benefits Of The 1031 Exchange?
The simple answer is leverage. A 1031 exchange enables an investor to save 30% to 40% tax (combined state and federal taxes), and use that money to purchase a replacement property. For instance, if you had a $1.5 million gain, and assuming a 33% tax, you would pay $500,000 in taxes. The 1031 permits you to take the $500,000 and reinvest it with the other $1,000,000, so that you are able to purchase a $1,500,000 property. The leverage comes from the additional real estate you can purchase. Instead of buying a two-family property, an investor could buy perhaps a six-family property by investing the extra $500,000 that would have been paid in tax. I regularly practice in NYC where a studio apartment is often more than $500,000, so this example is just that. It is possible in Texas or Kansas, but for those in NY the same principle applies. If you purchased a property for $1,000,000 and the property is now worth $4,000,000, the tax alone could be $1,000,000 or more. How many additional units, or perhaps how much of a better property could you buy with $4,000,000 as opposed to $3,000,000?
What Is Depreciation? Why Is It Important To A 1031 Exchange?
Depreciation is an expense that reduces the value of an asset over time in the United States. It’s 26.5 years for commercial property. However, when a property is sold, the depreciation is added back into the basis, and the tax is figured out based on recaptured depreciation. An investor can defer that recapture by using a 1031 exchange.
How Do I Start The 1031 Exchange Process?
You can start the 1031 exchange process by selling an existing property. When you sign the contract of sale for the existing property, which for 1031 purposes is called the “relinquished property”, there should be wording that states that you desire to use the property as part of a 1031 exchange. A qualified intermediary is involved, and you must then identify a replacement property, subject to very specific rules, within forty-five days of the sale of the relinquished property. The government and the IRS have a narrow time limit – you cannot take more than 180 days from the sale of your old property to close on your replacement property. You must work with competent accountants, attorneys, and intermediaries to ensure that no date slips through the cracks.
How Can I Defer All Of My Taxes From The Sale Of My Property?
A 1031 exchange will help defer all of the taxes that would be due on the sale of the property. You can defer all of the taxes due on the relinquished property (the property being sold) after the sale of the property that hasn’t been purchased yet (the replacement property). Under the IRS rules, there is no limit. If two years from now, you sell the replacement property and purchase another one, you could file another 1031 exchange. If three years pass after that property is sold and you buy another property, you can do another 1031 exchange as well. If the original owner passes away, they can leave the property to their heirs. When the heirs inherit the property, they can get what’s called a stepped-up basis, and they’d pay zero tax. The heirs inherit the properties with the value as of the date of the original owner’s death. Therefore, if the original owner paid $2 million and the property is later worth $30 million, the heirs inherit it with a value of $30 million, and there’s zero tax.
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