In this two-part series, I'll cover the common scenarios of 1031 Exchanges.
Simply put, a 1031 tax exchange is a way to sell a property, reinvest the proceeds and defer the capital gains taxes down the road. But of course, there are a few conditions. Most importantly, the property must be an investment property. In this first part discussing 1031 Exchanges, I’ll cover the basics. In a second post, I cover how this might be applicable to a property that has previously been in use as a primary residence.
In a 1031 exchange, you must exchange “like kind” property, meaning that you can exchange a rental property for a piece of undeveloped land, a condo for a single-family residence, a single-family residence for a percentage in a commercial building, and so on, just not a helicopter for a house. It needs to be an exchange of real estate property for real estate property.
For exchange transactions, you still work with a realtor, but also bring in the services of a 1031 exchange company to sit in the middle of the transaction to handle paperwork and receive and disperse the funds. It’s much like rolling over a 401K, you can’t take control of the proceeds yourself, they must be rolled into another account, or in this case, another property to defer the taxable gain. The tax liability is still there, but only becomes payable when you sell without doing another exchange. Even better, if you keep the property until death, the assessed value or new cost basis is stepped up to the current market value for your beneficiaries. This avoids their having to pay any capital gains taxes on the property. This is why you might hear tax advisors chanting the mantra, "defer, defer, die".
So, what are some scenarios where people benefit from 1031 exchanges?
1. If you own a rental/vacation home and want to switch the location and don’t want to incur a taxable gain, this allows you to do so as long as the property has been a rental for at least 2 years. There are very specific guidelines about how much you can personally use the property so you should always consult a 1031 exchange expert for guidance.
2. If you are a long time owner of rental property, you may have reached the end of the depreciation scale, resulting in more of the rental income being subject to income tax. Using a 1031 exchange for a new property allows you to restart the depreciation clock. Remember, you can depreciate investment residential property over 27.5 years.
In part two of this series on 1031 Exchanges, I' explain the ways a 1031 exchange can be applied to a primary residence.