Home sellers usually don’t have to pay any capital gains taxes on profits made upon the proceeds of a sale because they are typically using those proceeds to be put towards another home to move into.
But what about real estate investors who are selling for a profit without necessarily using the property as a primary residence?
In the US, capital gains taxes are applied to any profits made on real estate sales whereby the property has increased in value, with certain exceptions. The rate charged depends on the type of investment and your income tax bracket, but they cap at 25%.
The good news is that real estate investors have an out when it comes to paying capital gains taxes: the 1031 exchange.
What is a 1031 Exchange in Real Estate Investing?
Section 1031 of the IRS states that any gains realized on the sale of real estate will not be recognized if the property is “exchanged” for a similar property. Basically, a 1031 allows investors to “defer” having to pay capital gains taxes on a property after selling it, as long as the proceeds are put towards another “like-kind” property.
That means if you’re selling an office building, you can use Section 1031 to avoid paying capital gains taxes if you purchase another office building for similar purposes, for instance.
A real estate deal that falls within the stipulations of a 1031 exchange means there will be no capital gains taxes involved or at least a limited amount. You can “exchange” like-kind properties as often as you want, and you would only be subject to paying these taxes if you finally sell for cash.
In addition, the property being sold must be considered an investment property and not a primary residence, and the exchange must take place within a certain time frame.
What is Considered a “Like-Kind” Property?
As already mentioned, one of the rules of a 1031 exchange is that the new property being purchased must be similar to the one sold. So, what exactly is classified as a “like-kind” property?
Basically, this just means that the new property must be of similar character as the old property, though they may differ in quality. The asset must be basically the same, so when it comes to real estate, just about any type of real property can be exchanged.
For instance, you would be allowed to exchange a triplex for an office building or a single detached home for an apartment building, as long as the properties are located within the US. But you wouldn’t be able to exchange your property for a vehicle, for instance, because they are fundamentally different.
Primary residences do not fall under the 1031 exchange rule, as previously mentioned.
There’s a Time Limit on 1031 Exchanges
In order to comply with the IRS’s 1031 exchange rule, you must purchase another property within a certain amount of time, namely 180 days. You can’t sell a property and wait around for as long as you want before purchasing another with the proceeds of the sale. As it stands right now, you’ve got a maximum of 180 days to find and buy another like-kind property in order to be able to defer paying capital gains taxes.
Types of 1031 Exchanges
There are a few different types of 1031 exchanges, including the following:
- Simultaneous 1031 Exchange – This type of 1031 exchange occurs when the deals of the newly purchased property and original property close on the same day.
- Delayed 1031 Exchange – This is the most common type of 1031 exchange and occurs when the original property is sold first and the deal for the purchase of the new property takes place after the fact.
- Reverse 1031 Exchange – When a new property is purchased first before the original property is sold, this is known as a reverse 1031 exchange. Most of the time, such situations require all-cash purchase, as banks don’t typically extend loans for reverse exchanges.
- Construction 1031 Exchange – These types of exchanges allow investors to improve the replacement property using the tax-deferred money while it remains in the hands of a middleman during the 180 day period.
The Bottom Line
Real estate investors can definitely save quite a bit of money thanks to the 1031 exchange rule. Considering how expensive real estate is these days, having to pay capital gains on each transaction can really eat into the profits of investors. When used properly, a 1031 exchange can help you continue to build wealth when investing in the world of real estate. Be sure to speak with a tax specialist and real estate professional to ensure you adhere to the rules in order to take advantage of this financial tool.