“1031 exchange” or “like-kind exchange” are terms you may have encountered in the real estate world. While the name might make it sound like a tax form, it actually refers to an entire type of business transaction. If you are interested in buying or selling investment property, it’s important to understand what this type of transaction entails. Once you learn the basics of 1031 exchanges, you’ll know what to expect and if you may benefit.
A 1031 exchange is a specific type of transaction involving the sale of an asset specifically as to avoid losing profits to taxes. In real estate, this would mean selling an investment property and using the money earned toward acquiring a different investment property. This way, the seller can avoid paying certain taxes they would normally be liable for in the property's sale.
According to Investopedia, the most common reason to use a 1031 exchange is to defer capital gains tax. Capital gains tax is based on the difference between the price you paid for an asset and the price you sold it for. Therefore, a bigger profit equals higher tax. When you complete a 1031 exchange, you may defer that tax as long as you don’t gain any additional monetary benefit from that original sale. You can technically defer this tax indefinitely, saving money to use in future investments.
Another tax incurred by selling a property is known as depreciation recapture. This tax is in place to balance out the deductions property owners can claim for depreciation in their tax returns. Depending on the seller’s tax bracket, this can add up to a big number on the tax bill for a property sale. 1031 exchanges can also allow you to defer this depreciation recapture tax to save money.
One of the key requirements for an 1031 exchange is that the property you buy must be “the same nature or character” as the property you sell, according to Millionacres. Though it might sound like it, this rule does not limit you to purchasing the same type of property in terms of style, function or size. You may “exchange” a retail property for a duplex, for example. You may even sell a plot of undeveloped land for a fully furnished office building. The “like-kind” requirement refers to the purpose of the acquisition rather than the literal purpose of the property. The required purpose is to hold on to the property as an investment.
There is an important difference between intending to hold a property as an investment versus the intent to sell that property quickly for a profit. Technically, there are no specific guidelines about how long you need to hold on to a property for it to be eligible for a 1031 exchange. However, most properties bought to “fix and flip” are not likely to be approved for this type of transaction. Always consult a qualified tax professional if you’re unclear about what does and doesn’t qualify as an investment property.
A 1031 exchange can be a great strategy for real estate investors. Though it’s a long and complex process, knowing the basics of the term will help you navigate the financial side of the real estate world with more confidence.
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