Maximizing investment returns means finding ways to keep more of your money working for you. Selling an investment property often comes with a hefty tax bill, but a like-kind exchange offers a way to keep your money invested while deferring capital gains taxes. You can continue growing your real estate portfolio without an immediate tax burden by exchanging one investment property for another. Understanding the process—and working with a legal professional—can help ensure a smooth, tax-efficient exchange. Here’s what you need to know before getting started.
What Is a 1031 Exchange?
When you sell an investment real estate, you are required to pay capital gains tax on your profit from the sale. However, you can delay this tax payment if you use the proceeds from the sale to buy another investment property. So, a 1031 exchange is called a “like-kind” because you are using the money to buy like-kind investment real estate. The IRS uses a broad definition of what like-kind property can be. Generally, the original and replacement property needs to be an investment property or used for a trade or business. The properties don’t need to be exactly the same. They can be different in quality, type, and grade. To take advantage of a 1031 exchange, the new property should be of equal or greater value than the original one.
There are a few different types of 1031 exchanges. A deferred exchange happens when you sell the original property first and then later buy the second property. A simultaneous exchange is when the sale and purchase happen at the same time. A reverse exchange happens when you buy the replacement property before selling the original property.
How Does a 1031 Exchange Work?
Because a 1031 exchange claim can be complicated, consulting with a real estate attorney is wise. Having an experienced lawyer advising you will ensure you plan the sale and purchase carefully, paying attention to important details. The first step is to choose the investment property that you want to sell that would result in you owing capital gains tax. Then, choose the property that you want to buy. Be careful about choosing a property in another state from the original property. There could be additional tax consequences for buying and selling in different states. In addition, property within the United States is not considered like-kind to international property.
When it is time to sell, arrange for an exchange facilitator to hold the sale proceeds until you make the next purchase. This third party will hold the proceeds and ensure they are used for the next investment purchase. This person cannot be a family member or anyone with whom you’ve had a formal relationship within the last two years. To avoid all capital gains taxes, you should use the entire sale proceeds to purchase the next property. However, you do not have to use the entire proceeds. Instead, you can use a portion of the proceeds and pay capital gains tax on any unused portion. If you decide to do a reverse 1031 exchange, the intermediary holds the property instead of the profit. You also have a limited number of days to complete the sale of the original property.
Benefits for Small Business Owners
A 1031 exchange can benefit small business owners by allowing them to defer tax payments, giving them more capital to reinvest in the business. It also creates increased purchasing power because you have a reduced tax burden, creating more liquidity to make a real estate purchase. Avoiding capital gains taxes makes it easier to diversify an investment real estate portfolio.
Potential Drawbacks
Being aware of potential drawbacks is important, as 1031 exchanges are not perfect. There are strict rules that you must adhere to. Otherwise, you will end up owing the capital gains tax. This can create significant financial strain if you weren’t expecting to pay this tax. There is also a lack of liquidity when doing a 1031 exchange. The proceeds get held by an intermediary, making them inaccessible for other purposes until you are ready to buy.
Plan a Like-Kind Exchange
A 1031 exchange offers real estate investors and small business owners a powerful tool to defer capital gains taxes and reinvest in new properties. While a like-kind exchange can provide significant financial advantages, it also has strict regulations and deadlines that must be carefully managed. The process requires working with an exchange facilitator to handle funds properly and ensure that the replacement property meets IRS requirements. Speaking with a knowledgeable real estate attorney can help you avoid costly errors and ensure compliance with IRS rules.
Schedule a consultation with one of our knowledgeable attorneys to discuss your like-kind exchange.
