Financial Resource

If you plan on holding real estate as an investment, whether commercial or residential, then it is essential that you learn how to minimize your taxes as you buy and sell property. One of the best ways to reduce your taxes and quickly grow your wealth is to use a 1031 exchange as you trade between properties. Read this article to have the 1031 tax exchange explained in a manner that will help you understand why this is such an important tool for a real estate investor.

What Is a 1031 Exchange?

There are many terms that are used to describe the 1031 exchange. Whether it’s called a tax-free exchange, Starker exchange, like kind exchange, or tax-deferred exchange, this section of the IRS tax code allows investors to defer the taxes on the profit obtained when selling of an investment property. As long as you meet certain rules and reinvest that money into a new property your money stays untaxed, which means you are able to reinvest with more money than if you had to pay taxes on each transaction. This leads to a far more rapid growth in wealth versus paying your taxes after every transaction.

1031 Tax Exchange Rules

In order to qualify for these tax savings and deferment there are specific rules that need to be followed. To begin with the real estate investment cannot be your primary residence. It must be used for a commercial purpose like a strip mall, rental home, or apartment complex. Next, you must find a qualified intermediary who can help to make the transaction go smoothly. When you sell your property you cannot have the money deposited in one of your personal accounts. Instead the money is placed into escrow by your qualified intermediary as you go and look for the next property to buy. When you make your purchase the investment must be of like kind to your previous property and all of the profit, also referred to as boot, must be reinvested. Any profit that is not used to purchase the next investment will be taxed at the normal rate. The term like kind simply means that you need to purchase another commercial property. Investing in stocks or bonds would not count.

1031 Exchange Timeline

In addition to those real estate tax deferral rules, there is a timeline that must be met in order to qualify for this savings. First, you have 45 days from the closing of your original property to identify a new potential investment. You can identify several, and the one you eventually buy doesn’t have to be among that first group identified, but at least one potential property must be listed. Second, you have 180 days from the closing of your original property to complete the transaction and take ownership of the new real estate. There are no exceptions to these timelines, so it is an essential that an investor who would like to use the 1031 Internal Revenue Code to defer their real estate taxes acts quickly.

Tax Free Versus Tax Deferred

The 1031 tax-free exchange isn’t truly tax-free; it simply pushes back the timeframe when you have to pay the tax on the profit you make from a real estate transaction. By not losing 20 to 30% of your profit due to paying taxes, you are able to invest more into each purchase and quickly grow your wealth. But, a savvy investor has the opportunity to completely defer the taxes for their entire lifetime, and when the property is passed on to their surviving loved ones that real estate tax debt completely disappears.

If you own property that is used for commercial purposes and are not well-versed in the 1031 exchange, then you are doing yourself a great disservice and paying far more in taxes than you need to be. Now that you’ve had the 1031 tax-deferred exchange explained to you, it is a good idea to incorporate its benefits into your investing and tax reducing strategy.

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