Death and taxes are often said to be the two guarantees to expect in life. However, what we if we could tell you that the latter could be avoided to some degree – at least temporarily.
A 1031 exchange is a lesser known IRS process which enables personal investors and businesses to defer the tax on the profit from the sale of property that they have used in trade or business. These taxes can reach as much as 40% on any profit that you make. This means that if you sell your investment and make $100,000 clear profit, you might have to pay as much as $40,000 to the IRS in taxes, leaving you with only £$60,000 to take forward into your next investment.
However, with a 1031 exchange it is possible to defer paying that tax, and instead carry the entire profit from sale forward and use it in your subsequent investment. Essentially this makes it the equivalent of a 0% interest loan.
Of course, it is important to realize that you can’t just use a 1031 exchange any time and in any circumstances. If this was the case, no-one would ever pay any tax on their property purchases. Fortunately, there are very specific circumstances in which you can utilize the 1031 exchange process and re-invest the money that would have paid in tax into your next investment.
So, when exactly can you use a 1031 exchange in real estate?
You can use a 1031 exchange in real estate provided that the property you are selling has been used in trade or business and is being exchanged for a ‘like kind’ property.
As ‘like-kind’ property is described by the IRS as being ‘property of the same nature, character or class. Quality or grade doe not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land’. However, as with most things related to law, this definition is not clear-cut. The fact that you can also exchange an apartment building for raw land or a ranch for a strip mall are perfect examples of surprising but entirely possible 1031 exchanges.
Property that is held for productive use in a trade or business, or for investment, qualifies for a 1031 exchange, provided that you are not classed as a ‘dealer’. This term refers to investors who attempt to acquire and trade property very quickly – such as those people who flip houses to turn a profit. Although there are no set rules as to how long you must have held a property for before doing a 1031 exchange, the recommendation is that you wait a minimum of 12 months. Nevertheless, the purpose and motivation behind the acquisition and use of the real estate before selling it may be taken into account when determining whether or not you are classed as a dealer by the IRS.
Since dealing with a 1031 exchange is anything but straightforward, and there are many different regulations to comply with and traps to fall into, we strongly recommend that you entrust your exchange to a professional. All 1031 exchanges must be carried out through a qualified exchange facilitator regardless, and a professional can help to ensure that your exchange meets with the necessary rules and regulations to qualify – preventing you from getting stung for unexpectedly overdue tax months later.
If you would like more information on how to do a 1031 exchange, our expert team are on hand to help you benefit from this unfamiliar tax benefit. Get your free road map to get started today!