If you are a real estate investor or interested in becoming on, you should consider taking advantage of a 1031 exchange. This tax mechanism can help you maximize the gains from your portfolio. Learning how to use this tool for the greatest possible benefit can help you to significantly increase your wealth.
What Is a 1031 Exchange?
When you sell real estate, you owe capital gains taxes on your profits. However, many real estate investors are selling properties to reinvest in other properties. Paying tax immediately prevents you from reinvesting the entire value of the real estate. Fortunately, a 1031 exchange allows you to defer that capital gains tax until you cash out.
This is advantageous in many cases. However, in some cases, you may be able to reduce your eventual tax burden by not deferring. Understanding the rules of 1031 exchanges can help you to decide when is the right time to use one.
What Are the Rules of Using a 1031 Exchange?
Using this tax mechanism can be very valuable for real estate investors. However, it is important to understand how it works. These are some of the rules to keep in mind when using a 1031 exchange:
- You can’t use this mechanism by yourself. You need to work with an intermediary 1031 exchange company.
- Within 45 days of the sale, you need to identify possible replacement properties for the sold property (called the relinquished property). Within 180 days, you need to have closed on the replacement property.
- The 1031 exchange must be initiated before the sale of the relinquished property.
- The replacement property or properties must be of equal or greater value than the relinquished property. If it is not, you will owe capital gains tax on the difference.
- Every state has different fees for using an exchange. Expect to pay between $800 and $1,200.
- The exchange does not need to be one-to-one. You can sell a property and invest in multiple properties. There is no limit but there are special rules if you purchase more than three.
Is a 1031 Exchange Right for You?
With these rules in mind, consider whether you want to use a 1031 exchange for your next investment property sale. In many cases, it is advantageous to use one. However, you may not want to if you are currently in a low tax bracket and could avoid or minimize capital gains anyway. Understanding the value of this mechanism will help you to maximize your real estate wealth.