DOING THE MATH ON CAPITAL GAINS AND THE 1031 EXCHANGE
If you’ve ever sold a home, you’re probably familiar with the Capital Gains Tax. That is what you pay on any profit from the sale of an investment. This is the government’s way of getting a piece of the accrued appreciation of your home. For those who have owned their home for more than a year, congratulations! You have an investment asset.
Before making any decisions on selling, it’s important to do the math first. At the most basic level, a 1031 Exchange is the swap of one business or investment asset for another. Although it is not restricted to only real estate, it is definitely where most of the discussion takes place. The majority of swaps are taxable as sales, but if you meet the requirements, you can have limited or no taxes due at the time of exchange. This means you can change the form of your investment without cashing out or recognizing capital gains, allowing your investment to grow tax deferred. And, there is no limit to how many times you can do it.
Sound too good to be true? When it comes to a 1031 Exchange, special rules do apply and that is why it’s crucial to get assistance from a professional. But as a model for good practice, here are 5 things you need to know now.
It is not for personal use. A 1031 Exchange is meant for investment and business properties only, so you can’t swap your primary residence for another home or investment property.
You can exchange like-kind property. The key is the use of the term, “like-kind” in this guideline because it refers to the nature of the investment rather than the form. The rules are surprisingly liberal. For example, you can exchange an apartment building for raw land or a rodeo horse ranch for a strip mall. Again, be careful of special rules that may apply.
You can do a “delayed” exchange. The odds of finding another person with the exact property you are looking for at the perfect moment in time is pretty slim. That is why most exchanges are delayed, three-party or Starker exchanges. In this scenario, a middleman “holds” the cash after you sell your property and uses it to “buy” your replacement property.
Consider your other mortgages and debt. This is one of the primary ways people get into trouble. Often times you will have cash left over after the transaction and if so, it will be taxed as a partial proceed or capital gain, taken from the sale of your property. If you don’t receive cash back but your liability goes down, that too will be treated as cash.
Close within 6 months. You must close on your new investment property within 180 days of selling the old one. Start counting when the sale property closes because the 45 days and 180 days run concurrently. Now you will have 135 days left to close on the placement property.
To do a 1031 Exchange right, there should be no tax and it will continue to grow tax deferred. There has been word that there is a proposal in Congress to repeal this section of the tax code, but in the meantime you want to take advantage of it.