Imagine, if you will.
You bought a property some years back, paid $500,000 for it, and paid the loan accordingly. Now, you owe nearly $200,000 on it. Feeling confident about the real estate market, you think: “it's worth a million now, what if I sell it and buy another place for $2,000,000?”
“Well, if we sell for $1,000,000 and pay off the loan of $200,000, forgetting fees, that leaves like $800,000, and it should be enough to buy a $2,000,000 property with, maybe, a little room to spare.”
Then, you go to your tax advisor for assessment, and they deliver the news: “you know, maybe up to 40% of your $500,000 gain goes to capital gains taxes.” So, the $800,000 you had put into that $2,000,000 property just went down to $600,000.
You are not sure if it is worth it. Who would want to pay $200,000 to the government? What if there is a way to defer those taxes?
There is a tool for that: the 1031 Exchange.
What is a 1031 Exchange?
First, let's define long-term capital gain, which is the profit you make on something you bought and held for over a year. The government, both the federal and the state, charges tax on that profit.
A 1031 Exchange allows investors to defer capital gains taxes from the sale of an investment property, provided that the funds are exchanged or reinvested in “like-kind” property. It is for a property used for business or investment and not personal residence.
In simple terms, a 1031 Exchange is where you sell the relinquished property, and roll the proceeds through a qualified intermediary into a replacement property, carrying over the original tax basis deferring any capital gains tax.
The replacement property needs to be of equal or a greater value of your relinquished property. If you had a loan on the first property, it would need to be of equal or a greater value as well. If you do not meet that criteria, some portion of your proceeds will need to go towards capital gains taxes.
When you sell your property, the funds go into an account controlled by the facilitator. You may not touch the money. The biggest no-no is for you to take possession of these funds. If you close escrow on your relinquished property and touch that money, you just had a taxable event. There is no exchange, and it is game over.
Things to Consider When Submitting a 1031 Exchange
When you are doing a 1031 Exchange, the timelines are critical. When you close escrow on your relinquished property, it is day zero. You have 180 days or until you file your next tax return to close escrow on the replacement property. It is not usually a problem.
The real challenge is you have just 45 days to identify the replacement property. In a hot real estate market it is sometimes hard to tie down that replacement properly. We advise that while you are in escrow, closing on the one you are relinquishing, make sure you start looking and figuring out what to do on your next property.
Four Facts for Special Circumstances for a 1031 Exchange
First, you can do it in any state within the United States, but you cannot exchange from the United States to out of the country or vice versa.
Two, you can do this with vacation homes, but there are specific rules that must be followed and require professional real estate and tax guidance.
Third, you can do this with properties under construction, but you have to be careful and know the rules.
Four, the reverse exchange, where you buy the replacement property before selling the relinquished one. Just know you have to be able to pay cash for the replacement property before selling your other one, and will still need an accommodator. It can be a useful tool for those who have the resources.
Closing Words
Doing a 1031 Exchange, taking profits or not and deciding to pay or defer taxes is complicated. It can be a lot. We recommend getting the proper tax, legal, and real estate advice. We are more than happy to talk with you and help walk you through the process of a 1031 Exchange.
Who knows? It might be the perfect strategy for you. Reach out, and we will be happy to help.
Dunfee Real Estate Services
DRE # 02026232
