Investing in real estate can be quite taxing in the literal sense. To reduce how much they have to pay as taxes, investors explore ways to escape taxes to spare the money for other productive ventures.
While you won’t find many legal tax-evading strategies online, they exist. One noteworthy tax-evading strategy that allows investors to increase their portfolios and simultaneously increase their net worth while evading tax is the 1031 exchange real estate rules.
In this blog post, you’ll learn the meaning of this rule and how it helps you as a real estate investor. Also, you’ll learn how to apply this rule to save on your tax, leaving more than enough for other ventures.
What Is 1031 Exchange?
1031 exchange is a real estate strategy that allows investors to swap investment properties, evading capital gains tax. The term got its name from section 1031 of the IRC (Internal Revenue Code). 1031 tax-deferred exchange is fast becoming popular among investors because it is effective if you play by the rules.
You can only exchange like-kind properties using the 1031 real estate exchange rules, and this rule implies that the homes should be similar irrespective of the nature or grade. You have only 45 days to identify replacement properties and 180 days for concluding all closing processes.
The IRS also states that the properties you are swapping must be solely for business or investment purposes, like vacation rentals. In other words, you can benefit from it using your personal properties. Also, the properties you’re exchanging must both be in the United States.
The IRS doesn’t limit the number of times you can use 1031 exchange. You can reinvest the profit from one investment to another without needing to pay tax unless you finally decide to liquidate the properties, after which the IRS will subject you to a long-term capital gains tax of around 15-20%.
Using 1031 exchange to evade tax isn’t flawless. Many shortcomings might end up losing you money in the long run if you’re not knowledgeable and careful enough.
Contrary to what you may think, you can exchange your former primary residence for a 1031 exchange under certain conditions. However, during the exchange, the apartment must qualify as an investment property.
Types of 1031 Exchanges
Due to the complexities associated with 1031 exchanges, this strategy has five different types. Here are the types of 1031 exchanges with a brief note explaining their meanings.
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Delayed Exchange
This refers to a scenario where the investor sells a property and purchases the replacement property within the given time frame.
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Simultaneous Exchange
Simultaneous exchange refers to the exchange type where the investor purchases the replacement property at the same time as the sold property.
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Delayed Reverse Exchange
In a delayed reverse exchange, the investor purchases the replacement property even before selling the current property.
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Delayed built-to-suit Exchange
This exchange type is when the investor builds the replacement property to suit their needs and specifications.
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Simultaneous Build-to-Suit Exchange
While the delayed built-to-suit exchange doesn’t require a completed replacement property, simultaneous built-to-suit involves completion of the replacement property before selling the current property.
Tips to Understanding IRS 1031 Exchange Real Estate Exchange Rules 2021
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Understand the IRS Perception of 1031 Exchange
This simply means knowing the entire stipulations of the like-kind exchange law from the IRS. This law states that investors can only exchange like-kind business properties. Under the Internal Revenue Code Section 1031, investors don’t need to recognize profit or loss.
Understanding these laws and the applicable exceptions will influence the potential success of your first shot at a 1031 exchange.
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Understand the concept of Eligible Properties
If you are an investor, consider taking time to understand the meaning of eligible properties. IRS defines them as properties with the exact nature or character, but not size. This rule excuses exchanging some types of investment properties, even if they differ by size.
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Know the Types of 1031 Exchanges
It helps to invest some time into understanding the different types of 1031 exchanges. Note that an accommodator will hold proceeds from the property an investor sells until the sale of the replacement property.
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Know and Follow Simple 1031 Rules
1031 might seem like a complicated strategy, but it’s pretty simple. When you plan and execute the plan carefully, and on time, everything should work out well. There are also some best practices you should always keep in mind some best practices during a 1031 exchange.
For instance, a replacement property should be equal or greater in value than the property you’re selling. As hinted earlier, you have a 45-day ultimatum for identifying replacement properties and 180 more days to conclude the purchase process.
Note that these ultimatums don’t only refer to working days. It includes all the days that elapse, including public holidays. Seasoned investors know this is little time to get a good deal in the hot real estate market.
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Work to Completely Erase Capital Gains Tax if Possible
One of the main points of the 1031 exchange real estate rules is to erase tax duties on investment properties. When the property owner dies and transfers ownership of the investment property to a relative, the IRS revalues it and restores all deferred capital gains tax.
All of these are vital knowledge to help you better understand the fundamentals of 1031 exchange properties rules.
1031 Exchange 5 Year Rule
The 1031 exchange five-year rule simply states that when a property is acquired through 1031 exchange and turned into a residential home, the homeowner must hold the property for five years, or the seller will need to pay total tax.
Note that for a 1031 exchange to be valid, you must compile and submit Form 8824 to the IRS. This form should include your tax return for the year the exchange took place, and you should also enter all the information requested regarding the deal in the form.
Conclusion
For many years now, investors have been using the 1031 exchange real estate rule to evade taxes strategically, and you can use it too. The only reason it may not work effectively is failure to familiarize yourself with the fundamentals. Hiring a licensed real estate professional or legal adviser will also make the process easier.