Using a 1031 Exchange to Reduce or Delay Taxation on Real Estate Gains

Real estate is an excellent wealth-building tool. It tends to offer stable appreciation, utilizes tax benefits to accelerate gains, may provide steady cash flow, and the IRS generally taxes profits at the lower capital gains rate.

In addition to these benefits, you may qualify to further delay paying Uncle Sam on profits through a 1031 Exchange.

What is a 1031 Exchange?

Typically, when you sell an investment, you owe the IRS up to 20% in capital gains on profits as long as you hold the asset for a minimum of one year. While this rate is significantly lower than what you pay on earned wages, it reduces investable dollars by 20%.

A 1031 exchange, otherwise known as Internal Revenue Code Section 1031, allows you to defer capital gains on investments by trading one property for another. The process involves selling one investment and taking the proceeds to buy another qualified asset without cashing out or paying capital gains on profits. After the exchange, the investment continues to grow tax deferred, building wealth faster.

The IRS does not limit the frequency or number of times you can use a 1031 exchange. Some investors use the strategy to delay taxation until retirement, while others put off paying taxes permanently, giving heirs a tax-free inheritance.

Regardless of how you utilize a 1031 in your wealth-building strategy, it’s essential to understand the IRS rules to gain the benefits.

The General Rules for a 1031 Exchange

  • The asset must be held for business or investment purposes. (You cannot use the property for personal use.)
  • You must purchase like-kind assets. You can exchange a business for a different company or one property for another.
  • Under certain conditions, a 1031 exchange could apply to a former primary residence. However, the personal exemption is often more valuable if you qualify.
  • When using 1031 for depreciable property, you could be subject to depreciation recapture, which the IRS taxes as ordinary income. An example might be swapping a building for raw land.
  • The Tax Cut and Jobs Act restricted the use of personal property in 1031 exchanges.
  • A qualified intermediary must hold funds if the swap does not occur simultaneously.
  • You must identify a maximum of three replacement properties within 45 days of the property sale.
  • You have up to 180 days from the sale of the first property to close on the second.
  • A reverse exchange permits purchasing a replacement property before selling the original asset. The identical timeframe applies to the reverse exchange.
  • Any remaining cash after purchasing the new asset becomes taxable at the capital gains rate.
  • When the new loan on the property requires less debt than the previous asset, you could owe taxes on the difference.
  • Using a 1031 exchange as an estate planning tool could allow you to delay taxes until death and transfer the asset tax-free to heirs.

A 1031 exchange could grow your real estate portfolio faster and increase your wealth by deferring taxes and allowing you to reinvest all capital gains in a new property. In our apartment syndications we generally accept 1031 exchanges for investors, with some minimum amounts, and often facilitate 1031 exchanges to another apartment syndication upon the sale for those investors interested. To learn more about creative ways to save money on taxes with real estate syndications, watch our short introductory video to learn more.

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