One of the major expenses that real estate investors run into is capital gains taxes. Every time a property is sold, these taxes can create a hefty burden on your profit margin. But there’s a way around that, if the purchase falls into the right category. The IRS allows sellers to defer capital gains taxes by doing a 1031 exchange.
Under this type of exchange, the property has to be held as an investment, not as a principle residence; it has to be exchanged for like-kind property; and there are specific time frames that have to be met. Identifying situations that qualify can be tricky, but learning how to find those deals is a great way to keep your profit margins high. Here are five tips for identifying a 1031 exchange replacement property.
Tip #1: Follow the “3 Property Rule”
This rule is set forth by the IRS, and allows the investor to identify up to three possible replacement properties for the future. They have to eventually acquire one, two, or all three of the properties.
Tip #2: Follow the “200% Rule”
Within the three property rule from above, there is another rule that can make it easier to fill the quota. As an investor identifies those three possible replacement properties, their total fair market value (of all three properties combined) cannot exceed 200% of the fair market value of the relinquished property.
Tip #3: Alternatively, follow the “95% Rule”
This isn’t a commonly applied rule, but it can be in certain situations. This rule states that as the investor identifies the three properties, that total no more than 200% of the value of the relinquished property, they also agree to acquire at least 95% of the total value of the three identified properties.
These first three tips will help you narrow down the many options you may have for real estate investing. By the time you find three properties that work for your investing budget, and that meet the 200% Rule, you’re likely to have eliminated most or many of the options.
Tip #4: Be Sure You Identify the Properties Correctly
The identified properties for potential acquisition must be identified in writing. This document has to be signed by the investor, stating that all properties have been legally and accurately described. The address and legal description of the property must be present, and the percentage share of a property that has multiple investors is also required on this document.
When the property is acquired, it must be “substantially the same” as what was described in the document. The IRS can be ambiguous on what this phrase means, but in general, the property has to have the same basic nature and characteristics.
Tip #5: Make Sure the Right Person Gets the Information
After ensuring that the identifying document is accurate, the investor has to provide the information to whomever is responsible for transferring the property to the investor; alternatively, anyone involved in the exchange, like the title company or the escrow agent, must receive the document. This person cannot be a family member or the investor’s real estate agent.
These five tips will help you ensure that you’ve identified the right replacement property for a 1031 exchange.