1031 Tax-Deferred Exchanges
One Of Uncle Sam’s Biggest Gifts To Real Estate Investors…
The phrase 1031 Tax-Deferred Exchange is a mouthful and those words alone can be very intimidating to some people. But if you’re a real estate investor it’s definitely something you should know about, for it could save you big-time when you sell a piece of investment property.
In layman’s terms, a 1031 exchange allows a real estate investor to sell one property, buy another and defer capital gain taxes on the sale to a later date. And in certain instances, that ‘later date’ may eventually disappear altogether.
You probably already know that owner-occupants don’t pay taxes on the first $250,000 (singles) or $500,000 (married couples) of profit when selling a home that they’ve lived in for two of the past five years. But that benefit only applies to your principal residence. When you sell an investment property, the entire profit is normally subject to capital gain taxes. And that can cause many investors to hold onto rentals that they’d rather sell.
And that’s where the 1031 Exchange comes into play.
As long as you adhere to the time frames specified for such an exchange, you can sell one investment property and buy another while deferring the capital gain tax from the one you’re selling. That profit essentially gets tacked onto the new property, so when you sell the replacement property down the road you’ll have to pay the tax you deferred plus any profit on the new property.
But, if you keep the property until you retire, you might be in a lower tax bracket by that point. Or, if you eventually move into the new property and live there for two of the following five years, it would become your new principal residence. And assuming the aforementioned $250k-single/$500k-married exemptions still apply by then, all that accumulated gain might disappear altogether.
That’s just what happened to one of our past clients. You can read their story in the Tales From The Trenches section of this website. They sold their Benicia rental and bought another rental property out of the area that would become their eventual retirement home. And by doing so they wiped out the capital gains tax from the sale of their townhome.
Finally, as noted above, in order for a 1031 exchange to be successful, you must adhere to strict time frames. Miss a deadline by one day and the sale immediately becomes a regular transaction without any tax-deferral benefits.