Real estate investing has some tax benefits. The 1031 exchange is a great example. Here is an investor’s 1031 exchange for dummies guide.
Investors or small business owners selling their commercial properties never end up getting as much as the buyers pay. You must cover the real estate agent’s commission, pay off your mortgage, and sometimes even the closing fees. One thing often forgotten is the very expensive capital gains tax.
Depending on your income status and taxable income, the capital gains tax can add a tax on your sale’s profits of up to 37%. Learn how to avoid this costly tax by reading our brief guide to 1031 exchange for dummies below.
1031 Exchange for Dummies: Defining a 1031 Exchange
The capital gains tax only applies to properties you own beyond your main home, including a second home, condo, or business property.
A 1031 exchange allows you to avoid this massive tax when selling your property if you invest the funds into another non-main home property.
This frequently overlooked loophole can easily save you tens of thousands of dollars when done correctly.
How to Do a 1031 Exchange
In order to perform a 1031 exchange, you need to follow very specific rules set by the IRS.
1. Qualify as a Like-Kind Property
The property you choose to invest in must be of a similar kind to the property you want to sell. Many people do not realize this when learning how to do a 1031 exchange. So if the property you want to sell is a business or trade property, the property you buy with the profits must also qualify as a business or trade property.
2. Meet the 45-Day Window of Identification
The IRS requires you to submit identification of the new property you purchased or intend to purchase within 45 days of the first property’s closing sale date. The 45 days start counting down the first calendar day after closing. Even if the 45th day falls on a holiday, you must submit your identification by then and they permit no extensions.
3. Close within 180-Days
You must close on at least one of your new properties no more than 180 days after closing the sold property. The property purchased must appear on your identified property list received within the 45-day identification period. So after that initial 45 days, you only have 135 days to close on your new property.
4. Hire a Qualified Intermediary
As the seller, you may not access the allocated money between the sale of the first property and the purchase of your new one. You must hire an independent third party known as an intermediary or exchange partner to handle it. The qualified intermediary cannot be a family member or a business partner you worked with during the last two years.
5. Names on Title and Reverse Exchanges
The sold property’s title must list the same taxpayer as the new title. So if both you and your business partner appeared on the first property’s title, then you both must appear on the new property’s title.
However, the two properties cannot be owned under the same taxpayer name at the same time. The IRS will allow you to put the new property in an exchange entity, like an LLC, if you need to stay on the old title for a bit.
6. Reinvestment of an Equal or Greater Amount
Finally, the new property purchased must cost at least as much or more than the gain from the sale of the first property. The rule also states you must invest all of your cash profits into the new property. If you choose to hold onto the cash, the IRS taxes it at the standard income rate if you hold it for one year and 15% for more than one year.
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