What Real Estate Investors Need to Know About the 1031 Exchanges

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As a real estate investor, you’re likely already aware of the tax implications of selling investment properties and the profits made from such transactions. Normally when an investment property is sold for more than what was paid for it, capital gains tax needs to be paid on the profit. This can take a huge chunk off of your bottom line, but there’s this little thing called a 1031 exchange that can help keep some of that money back in your pocket.

Thanks to a 1031 exchange, real estate investors can defer paying capital gains taxes if the proceeds of the sale of one property are put directly towards the purchase of a new one. In this case, the transaction is seen as an exchange instead of a sale.

As good as this may sound, there are still some stipulations governing a 1031 exchange that all real investors should know about before taking advantage of them.

The Property Must Be For Investment Purposes

A 1031 exchange only applies to properties that are specifically bought and sold for investment purposes. That means you can’t take advantage of this tax tool when you sell your own personal residence. And while interests as tenants in common may qualify, exchanges of partnership or corporate stock interests don’t.

You Have 45 Days to “Designate” the New Property

From the moment you sell your original investment property, you have 45 days to find and “designate” in writing a new property that you want to buy. Any money that you make from the sale of the original property is held by a third party until the purchase of the new property closes.

The Deal Needs to Close No Later Than Six Months After Selling

The closing of the new property that you purchase needs to occur within six months (or 180 days) of the sale of the old property. You can’t drag on the closing of a new home if you want to ensure that your transaction qualifies for a 1031 exchange. This time period begins after you’ve found and designated the replacement property.

You’re Allowed to Identify More Than One Replacement Properties

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According to the IRS, real estate investors are allowed to identify up to three properties as the replacement property, as long as one of them results in a successful purchase. This gives investors some leeway in case one of the deals they may be working on falls through. 

That said, investors may be able to identify more than three replacement properties as long as they qualify under a specific valuation rule. In order to qualify for a 1031 exchange, the combined value of all identified properties cannot be any more than 200% of the value of the old property or properties.

The New Property Must Be Worth More Than the One Sold

In order to benefit from a 1031 exchange, the new property purchased needs to be worth at least the same amount as the property being sold. If you pay less for your new property, you’ll be stuck paying taxes on the difference between the two prices.

Any Reduction in Loan Liabilities Will Be Taxed

It’s important to take into consideration the mortgage that you carried for the old property versus the one you now carry with the new one. If your loan liability decreases, that amount can be taxed. For instance, if you carried a $700,000 mortgage on your old property and the mortgage on the new replacement property is $500,000, you’ll be considered to have a $200,000 gain that will be taxed.

The Bottom Line

The 1031 exchange is certainly a welcomed tool to help real estate investors reduce their tax obligations, but it still must be utilized properly in order to qualify and take full advantage of them. Before you decide to sell an investment property, speak with a professional accountant or tax consultant who can help guide you and ensure that all your ducks are in a row before you finalize any transaction.