The majority of new millionaires in the US have built their fortunes through real estate. Far more than those who build a successful business or buy the right stocks at the right time are those who get rich by buying property.
There are countless ways that real estate can help you grow your wealth. But one of the best-kept secrets to investing in real estate is the tax benefits.
Real estate is very tax-friendly. There are many ways to pay little or no taxes during the year, such as with the 1031 exchange.
Interested in learning the 1031 exchange basics, so you can start building your real estate empire? Whether you have a single property or own hundreds of units, the 1031 change is available to you to invest in more property instead of paying taxes on your gains.
Keep reading our real estate investing guide below for helpful investing tips regarding taxes.
What Is 1031 Exchange?
The 1031 exchange, otherwise known as the “like-kind exchange,” refers to Section 1031 of the IRS tax code.
When performing a 1031 exchange, you are selling one property and buying another property, or multiple properties. When selling your current property, you won’t have to realize any losses or gains. That means no capital gains tax on the sale of the property.
But this is only allowed when using the proceeds of the sale to purchase property of equal or greater value in a set time period. So you aren’t pocketing the gains, but you are recycling them.
This keeps those funds in real estate, which continues to benefit society at large. The more you invest in real estate, the more housing is available to the general public. And the government awards these activities using these tax incentives.
1031 Exchange Example
So how does a 1031 exchange look in the real world? Say you bought a single-family home for $100,000. Five years later, thanks to rapid appreciation, the home is now worth $300,000.
If you were to sell the property, and pocket the gains (not performing a 1031 exchange), you would have to pay capital gains tax on those gains. You would be subject to the long-term capital gains tax. The rates depend on your current income level but can either be 0%, 15%, or 20%.
So you’d pay the appropriate tax on the profits from the sale (in this case, $200,000. Paying 20% tax on that means forking over $40,000 to Uncle Sam.
If instead, you use the 1031 exchange, you would get to defer those capital gains taxes. So you can keep the full $200,000 profit, so long as you put it into your next investment property of equal or greater value.
Typically, investors will sell a smaller property to acquire a larger, more expensive property that can generate more income.
You can continue using the 1031 exchange over and over again to defer taxes. However, the taxes don’t go away, and there is an expectation to eventually pay them.
Once you finally sell the last property and cash out your gains, you’ll only have to pay one tax, using the tax rates noted above, on the current gains.
1031 Exchange Basics
The 1031 exchange applies only to investment real estate. it doesn’t apply to assets like stocks or bonds. Nor does it apply to a personal residence. It can be used on residential rental real estate or commercial real estate.
The idea of the 1031 exchange is that you are swapping one asset for another. In a perfect world, this would mean finding someone with a property that you want, who is willing to trade that property for yours.
But this scenario is extremely unlikely to play out. So the 1031 exchange allows you to swap properties by selling your first property first, then buying another with those proceeds in a short time window.
To perform a 1031 exchange, you need to work with a qualified intermediary. This third party holds the cash netted from the sale of the first property and delivers that cash to the seller of the next. For the exchange to work, you are not allowed to touch the proceeds yourself.
1031 Exchange Timeline
To successfully perform a tax-deferred exchange, you need to have a new property identified in writing within 45 days. You don’t need to close on the purchase, but you do need to have the property identified.
You can designate up to three properties that you’d like to acquire, with the ultimate goal of closing on one of them. Since one or more properties might not work out, it’s good to have a backup plan.
You have 180 days to close on the new property. This timeline starts when you close the sale of the original property. Extended time is often needed when looking for funding options for investment property.
You can also complete the process in reverse. For example, you can buy a new property first, before selling one.
You’ll work with the intermediary to then sell a property of your choosing to roll the funds into retroactively.
The biggest problem investors face when performing a 1031 exchange is the short window to find a new property. 45 days go by quickly, so you need to have a plan in place before you sell your property.
Luckily, companies like this investment corporation, specialize in properties that are perfect for those looking to redeploy their capital quickly. With nationwide relationships with real estate companies, there is always an opportunity to buy into within just a few days, saving you the hassle of starting from scratch and the risk of failing to perform the exchange.
How to Perform a 1031 Exchange
Before you start the process of selling your property, you’ll want to contact an intermediary. This is the third party that facilitates the transaction.
Along with holding the proceeds from the sale, they can also advise on best practices and strategies. Because the 1031 exchange involves a complicated tax code, it’s best to consult professionals before taking action, which can help you avoid costly mistakes.
Investing for Beginners: Grow Slowly With Exchanges
Using the 1031 exchange to expand your portfolio is a powerful strategy for beginners and professionals alike. While the 1031 exchange basics can be a little difficult to navigate at first, the process is actually quite simple.
If you plan to grow a large portfolio over time, you’ll likely utilize this powerful tool a number of times.
Looking for more investing tips and tricks to help you grow your wealth? Head over to our blog now to keep reading.