Real estate investors need to take advantage of every opportunity to minimize their taxes. That doesn’t mean that it’s OK to commit fraud. You just leverage the existing rules and use them to your advantage.
One of those lies in section 1031 of the IRS code. This allows you to sell a property without paying capital gains taxes, which is called a 1031 exchange. It sounds like a dream come true, doesn’t it?
The thing to know is that you have a lot of 1031 exchange rules. If you don’t know the rules, the transaction can fall apart and you wind up owing a lot of money in taxes and penalties.
Keep reading to learn more about 1031 exchanges and what those tax rules are.
Like-Kind Property
When you first hear that you can sell a property without paying capital gains, you might want to go crazy buying up and selling properties.
The reason why a 1031 exchange is called an exchange is that you have to invest those profits to purchase another property.
The property has to be used for business. You could be a real estate investor selling one apartment building in one location to buy another in a separate location. You could be a business getting ready to sell a property to relocate buy another location.
There are a lot of question marks around what a like-kind property is. They have to be similar properties, but you are allowed to sell a building to purchase land.
1031 Exchange Rules Have Strict Deadlines
The most important things to know about a 1031 exchange are the rules around deadlines. Timing is hugely important in these exchanges. If you miss a deadline by even a few minutes, the deal will fail.
Here is the breakdown of a 1031 exchange timeline.
When you sell your initial property, you have 45 days to figure out which property you’re going to buy next. That property has to have a value that’s as much or more than the initial property.
You have 180 days from the sale of the initial property to close on the new property. Keep in mind that these are calendar days. Weekends and holidays aren’t taken into consideration.
Tax Season Can Complicate Deadlines
Here’s where the 1031 exchange rules get confusing. If tax time falls in the middle of that 180 day period, you have to close on the new property by the tax deadline, which is around April 15.
So, if the sale of your first property closes on October 17 or later, you need to close on the second property before Tax Day.
There is one way around that: you can file a tax extension. That will give you enough breathing room to close the deal and file your taxes.
Keep in mind that if you do file a tax extension you may be charged interest and penalties if you owe the IRS money. They expect that you’ll pay your taxes in full in April, even if you don’t file your taxes until October.
Using a Qualified Intermediary
How does the money move during a 1031 exchange? In a normal real estate transaction, you might pay cash for a property to purchase it or take out a loan to finance the purchase.
When you sell the property, you get the proceeds from the sale. The bank gets paid if there’s any money owed on the property, closing costs, and real estate agents are paid, too.
When you sell a property in a 1031 exchange, you have a much different experience. You have to use a qualified intermediary. When a property sells with the intention of rolling it over into a 1031 exchange property, the intermediary gets the proceeds and holds them.
The reason why is simple, you don’t see or access the capital gains from the sale of the property. You see the profits; you have to pay taxes on those profits.
A qualified intermediary will hold the funds and release them when it’s time to close on the replacement property.
What Happens If You Don’t Follow the 1031 Exchange Rules
Here’s a common situation in 1031 exchanges. You sell your investment property and the profits are sent to the qualified intermediary. At this time, any capital gains taxes are deferred, meaning you don’t have to pay them right now.
You identify a property to purchase with the 1031 exchange within 45 days. Unfortunately, the closing will take more than 180 days to complete the sale. On day 181, the qualified intermediary will send the funds from the sale of your initial property.
The capital gains are no longer deferred and you now have to pay taxes on those profits.
Leveraging DSTs
If you have a hard time finding a replacement property, you can use a Delaware Statutory Trust, otherwise known as DSTs. These are trusts where investors pool their resources to invest in properties run by the trust.
Why use DSTs? They give you a lot of benefits that make it easier to get passive income from your investments.
Know How to Use 1031 Exchanges
For business owners and real estate investors, 1031 exchanges are a great way to build up your real estate portfolio without paying capital gains taxes.
In order to defer those tax payments, you have to be aware of the 1031 exchange rules. Otherwise, you run the risk of a 1031 exchange failing. That will result in a potentially large tax bill for you.
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