Real estate investment is profitable as it is complex. At least, it’s complex when it comes to understanding what goes on in terms of what you can do around capital gains taxes. So, what is a 1031 exchange?
This shortlist will give you a glimpse into its implications and advantages, and why you should consider signing up for this IRS code.
1031 Exchange: FAQs To Understand
Every new investment you make on new properties will result in what’s called “capital gains”. It’s the phrase used for any profit earned from any tangible asset that has been sold, and within that period, has increased in value.
“Capital gains taxes” refer to taxes from said capital gains. To put this into perspective, here’s an example. Say, you sold a property worth $100,000 but its original value was at $70,000. Your capital gain is $30,000.
Now, out of the $30,000, the capital gains tax percentage will be calculated based on what bracket your income belongs to. Plus, variables such as whether you’re single, married, with a dependent, etc., are to be followed as well. The bracket for singles who earn at least $65,000 annually is to be considered within the 15% tax bracket.
Therefore, 15% of the $30,000-capital gains will be subtracted as your capital gains taxes.
We should have you note that this formula is applicable only on short-term capital gains taxes with respect to properties. For long-term capital gains taxes on properties, the percentage goes up to 20% (be sure to do your research on which bracket you belong to).
Properties Eligible For A 1031 Exchange
At this point, it’s important to emphasize that not all types of properties will qualify for a 1031 exchange. If that’s the case, which ones qualify? The answer— the 1031 code can only be applied to business or investment properties.
An investment property is a piece of land, an establishment, or both land and building that’s used for purposes of an “investment income”. An example of investment income properties are rentals, future resales, or a combination of the two.
Moreover, an investment property can be owned by a sole investor, a group, or even an investment corporation.
What Happens In A 1031 Exchange?
Through a one-to-one property “exchange” (hence the name of the IRS code), an investor swaps a property for another that’s regarded as of like-kind. However, this is, more often than not, much more difficult than it sounds.
So, what most investors do is go through a three-pronged approach. The middle-person takes charge of the money from the sale of the real estate, or “holds” the funds. And once the original investor finds another property to purchase, then, the middle-person can release said funds for the second sale.
The presence of this middle-person (a.k.a. the trustee, escrow holder, etc.) to hold funds is crucial because according to the 1031 exchange, the original investor is not allowed to take anything from the sale. That is if you want to be qualified for a tax deferral via a 1031 exchange.
Additionally, you are to complete your dealings for at least one out of a maximum of three investment properties you’ve selected within 45 days from the first exchange. This replacement property will be designated as the main replacement property.