What is a 1031 Exchange?
A 1031 Exchange is a way to defer capital gains tax when selling an investment property by reinvesting all proceeds into a new investment property.
Instead of taking a tax hit that could be as high as 35% on profit made from the sale, you can reinvest ALL (100%) of the proceeds towards a new investment property. Before we get to the nitty gritty, let's define three IRS terms I will use throughout the article that you may not be familiar with:
- Relinquished Property - During a 1031 Exchange, this refers to your existing investment property that you sell first. "Relinquished" basically means "Sold" in this scenario
- Replacement Property - This is the property you acquire with the proceeds from selling your relinquished property. Your "New" investment property.
- Qualified Intermediary (QI) - The designated "middle man" in the transaction who holds the proceeds from your relinquished property and transfers them to close the sale on your replacement property.
Imagine this scenario, you buy and sell an investment property and make $200,000 in profit. Once you sell that property, the government can tax the profit ($200,000) from the sale 15-35%. You can defer paying taxes if you roll all the proceeds and profit into another investment property.
In order to verify you did this, the IRS requires you to use a qualified intermediary, similar to an escrow/title company in a standard transaction, to hold your proceeds, transferring them back only when you close the sale of your replacement property.
A 1031 Exchange allows you to maximize your wealth by reinvesting your relinquished property appreciation into a replacement property, tax deferred.
Rules of the Exchange
There are a few additional guidelines to follow during the 1031 Exchange process (the IRS loves rules). Don't worry, the 1031 exchange tax code gives you some room to be creative. There are also many different types of 1031 exchanges you can take advantage of. Ask your agent for more details.
FAQs and Words of Wisdom
It's not completely "Tax Free"
It never is with the IRS. Its tax deferred, not tax-free, and you need to reinvest the proceeds into another like-kind investment (more on that below). Eventually, when the investment property is ultimately sold (not part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property is subject to tax.
You can break the Rules (but it'll cost you)
What happens if you don't 100% follow the rules? Don't worry, you won't get indicted for tax evasion, you'll just owe taxes on any profits you made from the sale that didn't go to the replacement property. Let's say you take $50,000 out of the sale profits from the relinquished property to buy a new car. Legally, it's your money, you can use it how you please. But, that $50,000 will now be taxed 20%-35%, bringing it down to $32,500 - $40,000. Capital gains taxes apply to every dollar you don't put towards the replacement property.
Select your Qualified Intermediary Carefully
This one kind of goes without saying but it's still important to mention. Make sure your QI, you know, the one in charge of holding ALL THE MONEY from the sale of your investment property, is actually "qualified" to do the job. Also, you cannot use a relative or anyone who has had any kind of financial relationship with you within the past two years prior to the close of escrow. This includes attorneys, real estate agents and certified public accountants.
Talk to your Tax Advisor
Before doing a 1031 Exchange, consult your tax advisor first. Everybody's financials and tax brackets are different, make sure it makes sense for you.
Do Vacation Homes qualify?
It's possible, but not all will qualify. For more information, contact your agent.