When you buy real estate properties for investment purposes, you set yourself up for a hefty gain, and hefty tax consequences. It is often possible for real estate investors to stay afloat by selling depreciating properties in order to buy more prime real estate, which incurs taxes on the sale of the first property. When you apply for a 1031 tax-deferred exchange, you give yourself a buffer before you have to pay those taxes.
Essentially, a 1031 tax-deferred exchange is a method by which you can exchange one investment property for another without incurring tax penalties. Rather than viewing the sale of one property as a capital gain, it is viewed instead as a transfer of investment to a new property that you must buy in a specified window of time. This is not something you can do over and over again—eventually you will have to pay taxes on your gains—but it gives you time to make a larger profit from the second investment property.
For example, let’s say that you currently own a residential rental property that you sell for $120,000. You want to buy a $70,000 fixer-upper instead, so you take your profit from the first rental property and purchase the second. If you use a 1031 tax-deferred exchange on this transaction, you won’t owe taxes on your profits until you sell that second property. This works for commercial properties as well, or any real estate you own for investment.
In order to complete a 1031 tax-deferred exchange for a real estate investment, you must formally identify the replacement property in writing and deliver such documentation to the CPA or attorney that is assisting you with the transaction. In most cases, written notice must be delivered within 45 days of the date you sell the first property.
In some cases, you will be permitted to identify two or more properties as replacement for your first real estate investment. This is tricky business, and shouldn’t be attempted without the counsel of a professional. For 1031 tax-deferred exchanges to qualify for approval, you must make sure that all your i’s have been dotted and all of your t’s have been crossed.
Requirements for Replacement Properties
In order for you to qualify for a 1031 tax-deferred exchange, you must make sure that the replacement property is considered “like-kind” to the first. Essentially, this means that both real estate investments will serve primarily the same purpose; if you were using the first property as a residential rental, the second must fulfill that same role.
If the IRS determines that your second property is of “unlike-kind”, you will owe taxes on the sale immediately, regardless of how much effort you’ve put into your application for tax-deferred status.
Completing the Exchange
Once you’ve identified the second property, you will usually have 180 days to complete the exchange. This means that within six months, you must have sold the first property and closed on the second. In some cases, your time limit might be shortened in accordance with the day on which your return is due, which is why many real estate investors choose to initiate these transactions in the summer—it gives them time to complete the transaction in full.
If you think that you might qualify for a 1031 tax-deferred exchange on your real estate investments, I urge you to take advantage of these reprieve. It can free up available cash and increase your chances of succeeding in real estate, regardless of whether or not you are a professional investor.
NOTE: This article does not constitute legal or financial advice. It is simply an overview of the topic. If you are interested in 1031 tax-deferred exchanges, talk to a CPA or attorney about your specific situation.