Capital gains taxes can eat into the profits a real estate investor makes when he or she decides to sell the property. However, it's possible to avoid paying taxes on your capital gains if you implement the right strategy while investing in real estate. One of these tactics is a 1031 Exchange, which allows real estate investors to exchange one investment property for another.
Any capital gains from selling the first investment property wouldn't be taxed as a result of putting this money into another investment property. If you're thinking of performing a 1031 Exchange on a rental property, you should be aware of some basic rules and guidelines before you begin this process.
What Is a 1031 Exchange?
A 1031 Exchange involves swapping out one investment property for another like-kind property. Any capital gains you make from the sale of your first property can be deferred, which means that you would be able to avoid paying capital gains taxes. Without engaging in a 1031 Exchange, you would be expected to pay taxes immediately after the sale occurs. It's common for investors to use the 1031 Exchange strategy when they are looking to sell or upgrade their current property.
1031 Exchange Rules and Timelines
When you want to exchange one of your investment properties for another, it can be difficult to find someone who wants to purchase the property you're selling while also having the property you want. Because of this issue, most exchanges occur as delayed exchanges.
Delayed exchanges are ones that involve a Qualified Intermediary (QI) who will hold the money you obtain from selling your property and eventually use this money to purchase the replacement property. This type of exchange is viewed as a swap. If you perform a 1031 Exchange, there are two distinct rules you must follow, which include the 45-day rule and the 180-day rule.
This rule involves identifying your replacement property. When you sell your first property, the cash from this sale will be given to the intermediary. If you received the cash immediately, you wouldn't be able to benefit from the 1031 Exchange tax advantages.
Within 45 days from the sale of this property, you will need to identify the replacement property to your intermediary. It's possible to designate as many as three properties as potential replacement properties as long as you eventually purchase one of them.
Another rule that every investor must adhere to when performing a 1031 Exchange is the 180-day rule, which requires investors to close on their replacement property within 180 days after the old property was sold. This period of time doesn't start after you designate your replacement property. If you take 45 days to designate a new property, you'll only have 135 days to close on the property.
You could also perform a reverse exchange, which allows you to purchase a replacement property before your old property has been sold. Keep in mind that the 45-day and 180-day windows still apply.
Potential Tax Implications
In the event that you have some cash remaining after the replacement property has been purchased, you'll receive it after 180 days. The remaining profit is taxed as capital gains. It's also essential that you take your loan into account. If the mortgage on your old property amounted to $500,000 but the mortgage on your new property is only $400,000, the difference between the old and new properties will be considered a gain. In this case, the gain is $100,000.
Choosing to exchange one rental property for another is possible as long as you adhere to the aforementioned rules. Making a mistake during this process could disqualify you from a 1031 Exchange, which means that any capital gains would be taxed.