As a real estate investor, one thing you’d like to hear is the high demand for rental properties. In fact, rental prices for one and two-bedroom units increased by 24.4% and 21.8%, respectively.
While it’s a good time to make money as a landlord, it’s also a good time to sell rental properties. Yet, if you want to avoid capital gains, you might be hoping to participate in a 1031 property exchange.
Knowing the rules is critical if you’re interested in 1031 exchanges. Not following the 1031 exchange rules can quickly exempt you and cost you dearly in capital gains taxes.
Read on to learn more about 1031 exchanges and how they benefit real estate investors.
What Is a 1031 Exchange?
Coming from Section 1031 of the U.S. Internal Revenue Code, a 1031 exchange allows you to sell one property and avoid paying capital gains on the property by buying a new property in its place.
To avoid paying those capital gains, the real estate investor must follow a series of strict rules to be eligible for a 1031 exchange.
It’s wise to work with a real estate specialist who’s well acquainted with the procedure to ensure you get the tax benefit.
How a 1031 Exchange Works
As a real estate investor, when you sell a property, and there’s a profit from the sale beyond what you paid, the IRS would expect you to pay taxes on that gain.
To avoid those taxes, you can take the money you gain and invest in like-kind property. (More on this shortly).
Property and 1031 Exchange Rules
The property you buy after your sale must be of like-kind. This means that the properties must be of a similar type. Most real estate can be considered like-kind to other real estate types.
The property must be similar in nature and function, meaning you can’t sell a rental apartment complex and buy a vacation home, for example.
The other 1031 exchange rules are essential too.
First, the property you buy must be of equal or greater value than the sold one.
Second, the property you intend to buy must be identified within 45 days of selling the previous property.
Finally, you have 180 days to purchase the replacement property.
Terms to Know When Participating in a 1031 Exchange
A few other terms also play into the rules of a 1031 exchange. Let’s take a closer look.
Qualified Intermediaries
The IRS says that the profits from the sale of property remain taxable until they are used on the replacement property. For this reason, they do not allow the funds to go to the seller.
The funds must be transferred to a qualified intermediary who holds the money and then is responsible for transferring it to the new property when it’s purchased.
The qualified intermediary acts as a facilitator for the 1031 exchange. Yet, they aren’t allowed to have any formal relationship with any parties involved in the 1031 exchange.
Depreciation
As a property investor, you probably understand depreciation for tax purposes. Depreciation plays an important role for 1031 exchanges too.
First, depreciation is what an investor writes off from wear and tear on a property on their taxes. When participating in a 1031 exchange, capital gains taxes get calculated based on a property’s net-adjusted basis.
The property’s net-adjusted basis is the property’s original purchase price, plus capital improvements minus depreciation.
Boot
The boot is the value between the property sold and the new property purchased.
This is important because if the replacement property is worth less than the original property, the difference is the cash boot and is taxable.
Boot can also come into play if the two properties involved aren’t like-kind properties.
Options for Identifying Property
If you recall, part of the rules of a 1031 exchange involves identifying the new property within 45 days of selling the previous property.
You can follow several rules to meet the 45-day rule requirement. Let’s take a closer look.
Three-Property Rule
The three-property rule allows you to identify three potential properties for purchase. Interestingly, the value of the identified properties doesn’t have to follow any specific rules.
If the one you choose is less than the previous property, you will be taxed though.
200% Rule
The 200% rule doesn’t limit the number of properties you identify. In fact, you can identify several. The rule is that the total value of the properties identified cannot exceed 200% of the property you just sold.
95% Rule
The 95% rule also allows you to identify multiple properties. The rule is that you must acquire properties valued at 95% of their total or more.
Types of 1031 Exchanges
There are various ways a 1031 exchange can proceed, as long as all other 1031 exchange rules are followed. The different types of exchanges have to do with when and how the new property is acquired.
The different types of exchanges include:
- Delayed Exchange
- Delayed/Simultaneous Exchange
- Delayed Reverse Exchange
- Delayed Buil-to-Suit Exchange
- Delayed/Simultaneous Build-to-Suit Exchange
It’s important to note, again, that because there are so many rules for a 1031 exchange and because the rules are so particular, you need to work with a real estate specialist who is well versed in how to proceed with this type of real estate transaction.
Benefits of a 1031 Exchange
While there are some particular rules for the 1031 exchange to work, there is a significant benefit to jumping through the IRS hoops.
If you can delay paying capital gains taxes, it’s to your benefit. Perhaps by the time you opt to sell your properties, you’re at a later stage of life where your income is lower, and the capital gains are less impactful.
Be sure to consult with your tax specialist before considering a sale to know the potential impact of capital gains.
Use the 1031 Exchange Rules to Expand Your Investment Property Portfolio
While 1031 exchange rules can be cumbersome, the ability to avoid capital gains taxes on a sold property often makes them worth the trouble. It also allows you to invest in bigger and more valuable properties to grow your real estate portfolio.
Schedule a 30-minute call with Memphis Investment Properties to learn more about our properties. We can tell you about options for investing in the Memphis market.