Smart investment planning: 1031 Exchanges

If you own (or are planning to own) investment real estate, you must carefully consider the tax consequences as they may have a substantial impact on your investment outcome. If you own investment property for a period of 1+ years and then sell it, the gain on the sale is considered a “long term capital gain” and it is taxed at maximum rates of 15%. If you purchase investment properties, rehab and upgrade them, and sell them within a short period of time, your gain is considered “short term capital gain” and it is taxed much more heavily. A smart strategy to defer the capital gains taxes (and it some instances, avoid them completely) is the 1031 Exchange strategy. The IRS Code in its subsection 1031, allows the tax free transfer of capital gains from one investment property to another investment property (or properties) of equal or lesser value. You can pretty much swap any kind of investment property for any other kind, for instance, an apartment complex with commercial land, a rental house for a shopping center. The exchange however, cannot happen between an investment house and your primary residence. If you hold the exchange property until death, the capital gain tax is erased altogether which makes this a great estate planning strategy as well.

As you should know by know, any favorable treatment from the IRS does not come without a slew of conditions. As such, to get these tax benefits you must follow certain rules:

1. The exchange property must be an investment property. It cannot be a primary residence or vacation home. Usually, if the exchange property is a rental, it must stay rented for two or three years. If you change your mind and want to make the property your primary residence, additional rules apply. First, the exchange must have been “bona fide” which means that you truly intended to keep it as a rental property and not as a primary residence. If you sell the primary residence and want to qualify for the capital gain exclusion of $500,000 (if married), you must live in the home for at least two years and a total of 5 years must have passed since the exchange. Under these conditions you could avoid paying taxes altogether.
2. When the first property is sold, you have 45 calendar days to identify  three (or so) potential properties that you are considering to purchase.
3. You have 180 days to close on one or more of the identified properties
4. You must not take the sales proceeds as they must stay with a third party accomodator such as a title company.

If these rules are strictly followed, you can enjoy the benefit of locking in the capital gains, deferring taxes as well as income. If you need to use some of the gains but do not wish to pay taxes on it, you can
borrow against the property tax free, after the exchange is completed.