You might have heard the term 1031 Exchange as a real estate term bandied about by real estate investors. But what is a 1031 Exchange and what do regular would-be investors need to know?
If you have sold a home in the last several years, you may have been aware of the tax rules which indicate that as long as a seller used your home as a primary residence for two of the last five years, he or she would not be taxed on the first $250,000 of capital gains when sold ($500,000 for couples). Meaning, if you purchased a home for $100,000 ten years ago, lived in it for at least two of the last five years and sold it for $300,000 last year, you would not owe capital gains tax on the $200,000 gained.
Additionally, if someone sells inherited property the value is considered “stepped up” to reflect current market value. For example, if someone were to inherit their parent’s home and the home has a current market value of $400,000 when inherited, then capital gains is only calculated on this value, not on the value when it was original purchased by the parents. If this person who inherited the home rented it out for three years and sold it for $475,000 they would owe capital gains, but only on $75,000.
In theory, a 1031 Exchange is similar to both of these scenarios combined in that it allows the investor to defer capital gains on an investment property by reinvesting those assets. One can invest in multiple 1031 Exchanges until death, passing on those assets to their heirs who then inherit these on the afore-mentioned stepped-up basis.
Stringent 1031 Exchange rules must be met in order to avoid capital gains tax:
- Both the “Old” property and “New” property must be investment property. Rental property, bare land or vacation homes are examples of these. In most cases, one can sell any type of property (such as an apartment building) and buy any other type of property (perhaps an office building).
- From the date of closing on the sale of the old property, the investor has 45 days to determine potential properties to buy. This is called the “45 day list”. Several potential properties should be identified to allow for some properties to not be feasible investment options.
- From the date of closing, the buyer has 180 days to close the purchase of whatever he or she is buying which must have been included on the 45-day list.
- By law, the proceeds from the first property must be held by a “Qualified Intermediary” (sometimes also called an “Accommodator” or a “Facilitator”) who is also responsible for the preparation of paper work required by the IRS to document the exchange.
- Whoever held title to the old property has to be the titleholder of the new property.
- All of the proceeds must be reinvested and the new property has to be at least equal to the net sales price of the old property. If not, tax is owed on the difference.
If you have a vacation or inherited property that you are thinking of selling, consider these rules and options to keep most of your cash in your pocket.