A 1031 exchange is a way to defer paying taxes on the gains you have made on your real estate. It is simply an exchange you make by selling your property, that’s qualified, and then acquiring another property (that’s also qualified) within a specific time frame. The entire process of selling and buying the property are identical to any ordinary sale, but a 1031 exchange is special because the transaction is treated as an exchange and not just a simple sale. This means that any appreciation gains that you realize once you sell your property are deferred to the future. A simple sale of a property is subject to a capital gains tax, but a 1031 exchange is not.
There are two major rules to follow when doing a 1031 exchange:
- The total purchase price of the replacement “like kind” property must be equal to, or greater than the total net sales price of the sold real estate property.
- All the equity received from the sale, of the sold real estate property must be used to acquire the replacement, “like kind” property.
There is also a timeline in which you should acquire the new property. Once you have sold your real estate, you have 45 days from the day you sold to find another property to purchase. According to the IRS guidelines, you must “identify” the property that you wish to purchase. After 180 days from the day you have sold your first property, you must close on a new property and hold ownership of the new one.
Since the IRS does not tax a 1031 exchange, you can potentially save you thousands, in taxes that you do not have to pay as long as you do a 1031 exchange to every property you sell. Why might that be a good thing? When you first start acquiring properties, more likely than not, they will be smaller properties like single family homes and duplexes. As time goes on, you may want to acquire more profitable properties such as multifamily units and apartment buildings. Since most banks require a 20% down payment or more on these types of loans, you can do a 1031 exchange on your single family houses to acquire larger apartment buildings.
Capital Gains Allowance
Aside from the 1031 exchange, if you do not want to keep buying properties, also know that the government allows you a capital gains allowance on any capital gains you realize in real estate. When calculating the profit you made from the selling price less the purchase price, if you had made improvements and major repairs on the property such as a new roof or furnace, you are allowed to deduct that from the capital gains. Currently the government allows every person a $250,000 allowance on any gain that they realize on their personal home, as long as they have lived in the property for at least 2 years. For married couples, they have a tax shelter of $500,000.