How Much Do You Have to Reinvest in a 1031 Exchange?

Real estate investors not only focus on picking the right properties, but savvy investors may also understand how to use the current Tax Code to their benefit. Policymakers have put certain provisions in the existing Federal Tax Code that incentivize investors into not only making an initial investment, but also benefits associated with maintaining their position as an investor. One such example of an incentive is the 1031 exchange. Understanding how these exchanges work, what they are, and the laws that surround them can ensure that you’re in a position to potentially enjoy sustained success as a real estate investor.

What Is a 1031 Exchange?

Ideally, your investment property generates profits, also referred to as capital gains. As is the case with any type of income, these capital gains are subject to federal taxation. However, by leveraging a 1031 exchange, investors can exchange their investment property for another like-kind property and defer the capital gains due at the sale of their property.

What Are The Benefits of a 1031 Exchange?

The primary benefit of a 1031 exchange is found in the fact that these exchanges allow investors to defer their capital gains taxes by trading one property for another. Technically speaking, you do sell the initial investment property; however, the funds generated by the initial sale must be used to purchase another commercial property within an allotted time period. The law currently allows for 180 days to pass between the sale of your first property and the purchase of another property, using the profits generated by the first.

Investors whose strategy involves being invested in real estate for the long-term are often drawn to 1031 exchanges, as they can continue to exchange properties, as long as they can find a like-kind property to trade for. In order to be considered like-kind, the properties don’t have to be exactly the same. Instead, they both must be revenue-generating property while meeting some other requirements set forth by federal policymakers.

How Much Do You Have to Roll Over?

As the 1031 exchange law currently stands, there is no certain amount that you have to use as a roll over while obtaining a new property. In order to better understand the principle of this rollover, let’s say that you decide to sell an investment property (an apartment building) that you currently own. The sale of the property generates $250,000. Within the next 180 days, you find a commercial space (an office building) for sale for $200,000. If the properties meet the requirements of “like-kind” properties, you will not be charged federal income tax on the $250,000 that you generated from the sale, as you essentially exchanged the property for another. There is currently no standard for how much of your profits must be used to purchase another property.

What Happens if You Don't Roll Over Everything?

Of course, the federal government does still expect you to pay taxes when applicable. To continue building on the example that we discussed, there’s still the matter of the $50,000 that you didn’t use to purchase another property. Obviously, this $50,000 is considered capital gains, as it was not used in your 1031 exchange. There is no additional penalty for not using all of the generated funds. Instead, these excess profits are taxes just like any other capital gains.

Knowing how to utilize 1031 exchanges and other legal tax deductions is paramount. Being able to defer taxes or offset capital gains is an important aspect of finding true, long-term success as a real estate investor.