The 1031 exchange is one of the most intriguing things about real estate investing. Basically, by performing 1031 exchanges and continuing to reinvest your profits from previous real estate investments, you can defer paying your capital gains taxes indefinitely. Of course, to take advantage of this tax exemption, you’ll need to know a few important rules. Otherwise, you could end up with a massive (and unpleasant) surprise from the IRS after you sell your next property.
1031 Exchanges Only Work for Investment Properties
Many people, when they first learn how a 1031 exchange works, will think to themselves, “Well, why don’t I do that with my home? I’ll just put the money I make from selling it into my next house, and I won’t have to pay any capital gains taxes…” Unfortunately, you cannot do a 1031 exchange on your primary residence. It can only be performed with investment properties.
So, if you’re planning on doing a 1031 exchange, think very carefully about your investment plan. You cannot sell an investment property and then buy a house to use as your primary residence until you decide to rent it out later, or vice versa. Both properties must be investments, not your residence (even on a temporary basis).
It Doesn’t Have to Be a One-for-One Exchange
A lot of investors use 1031 exchanges when they sell a smaller or less expensive property to buy a larger one or one in a wealthier area. This is not always the case, though. You may use the money you make selling your investment property to purchase as many new properties as you want, so long as their combined worth does not exceed 200% of the value of the property you’ve just sold.
You Don’t Have to Do the Exchange Immediately
Traditionally, 1031 exchanges are done swiftly, as you sell one property to buy another immediately. However, that’s not always possible (or even plausible) in modern real estate markets. A delayed exchange can be arranged, but you’ll just need to find a third party to hold your capital from the sale until you purchase your next investment property or properties.
But You Can’t Wait Forever – You Must Identify a Replacement Property
At the same time, you cannot simply put your 1031 exchange on hold forever. You must identify and designate a replacement property within the first 45 days after the sale of your first property. Because it’s common for deals to go south or fall through, you may designate as many properties as you want. Then you must move forward to attempt to purchase at least one of them, using the funds from your sale.
1031 exchanges could save you massive amounts of money in capital gains taxes, but keep these rules in mind before you attempt your first (or next) exchange. You want to ensure that you are operating within the law and that you are executing a legal 1031 exchange before you commit.