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Understanding a 1031 Exchange
Investing in real estate can be a highly profitable business, until you go to sell, then the tax man feels he can take a big chunk of your profits. Luckily for investors, Congress put rules in place over 100-years ago designed to defer your capital gain taxes, potentially indefinitely.
A 1031 Exchange, very simply allows someone to exchange one property for another ‘liked-kind’ properties, and not pay any capital gain taxes on the sale. Furthermore, liked-kind is a little looser than the name implies. For example, if you sell a duplex, you do not need to buy another duplex, but it does need to be real estate for real estate. You can even sale one property, and divide the gains to buy two or more properties, which is something I have done in the past personally.
1031 Exchange Timelines
The exchange rules come with strict timeline requirements that you must meet.
Identify a Property
You have 45-days from the sale date of your existing property to identify and provide the new property address. You do not need to close on it, but you must identify it within 45-days..
Days to Close
You have 180-days to close on the new property. The clock starts the day you sale the existing property, not the day you identify the new property.
Full Exchange, Not a Partial Exchange
The exchange rules require the new investment property to be “of equal or greater value” than the property being sold. Additionally, for a full tax deferral, the entire proceeds of the sale must be used to purchase the second property.
This means if you sell a property and net $300,000, you must use the entire $300,000 gain on the next property. You can’t only use $200,000 and pocket the difference.
If you don’t meet these rules, you are liable for the full capital gains tax on the sold property.
1031 Facilitator or Qualified Intermediary (QI) Required
Finally, you must use a 3rd party, known as a 1031 facilitator or qualified intermediary (QI) to handle the transaction.
Basically at closing, the proceeds from the sale can NOT go to you, and must go into an escrow account with the facilitator. When it comes time to buy, the money to buy, or down payment will come from the 1031 facilitator – who again, is just holding it for you.
Yes, the facilitator does charge a fee, but the fee is a drop in the bucket compared to capital gains taxes.
Not Scary, Not Complicated
Exchange, tax code, number of days, intermediary… It all sounds complicated and scary. The reality is that a 1031 Exchange is pretty simple and straightforward, and long as you follow the simply rules I’ve laid out.
If you are exchanging a property, and still need a mortgage loan for the balance, the investor loan experts at Cambria Mortgage have you covered, with a wide range of investor loan options, including not proof of income DSRC loans, bank statement loans, asset based loans, and of course, your plain vanilla 30-year fixed loans
Death and Taxes
A 1031 Exchange is a tax deferred strategy, not a tax-elimination one. Eventually most people sell the their properties, cash out, and don’t buy any new property. At that time, capital gains will need to be paid.
Well, unless you die. Typically at that time, the properties would go to your heirs. Your heirs are NOT responsible for any of the capital gains taxes. They simply inherit the property at today’s current ‘stepped up value’.
This simply means if you bought the property for say, $400,000 with a 1031 Exchange, at the time of your passing and their inheritance, the property is now worth $500,000. Your heir would simply have a “stepped up” or start value of the house at $500,000 – and could sell it with very limited, or no capital gains tax at all. How cool is that?
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