Investing in real estate can be a profitable way to make extra income while still working your regular job. In fact, many experts see real estate investing as a way to help them retire early. There is the sticky issue of taxes, but a 1031 exchange can help you salvage your profits.
What does a 1031 exchange do?
A 1031 exchange, also called a "like kind" exchange, is an IRS tax code that allows a person to "swap" one investment property for another while deferring capital gains taxes on the earnings, or profit from the sale. It is important to note that you do not keep your profits but rather are required to reinvest them in the next purchase. Think of it as the board game Monopoly, where you reinvest the money you spent on houses to buy a shiny, red hotel.
When you are ready to retire and liquidate your real estate investments, you pay taxes on the profit you made on the final sale.
What qualifies as a "like kind" property?
The "like kind" term is simply the IRS's way of saying that you need to use the 1031 exchange for similar properties. You can exchange a small apartment building for another, large apartment building. You can sell one piece of land and buy another. You cannot use a 1031 exchange for property outside the United States, however, as that is not considered "like kind."
Who can use a 1031 exchange?
Anyone that pays taxes in the United States can use a 1031 exchange. Whether you purchase investment property as an individual or use a personal business -- L.L.C., L.L.P., S-corp, or C-corp -- you can use a 1031 exchange to defer paying capital gains taxes on the sale of your investment properties.
How long must you hold a 1031 exchange property?
There is no minimum or maximum time that you need to own a property before you can sell it and use 1031 exchange. You can do it as often as you like as long as you follow all the IRS instructions and file the correct paperwork. Of course, most real estate will not increase in value enough to make a sale worth the effort until at least one or two years after purchase. Consulting a tax professional, real estate expert, or investment advisor with extensive knowledge of 1031 exchanges is advisable.
What can't you do with a 1031 exchange property?
You cannot sell a 1031 exchange property for a loss. That defeats the purpose of the program. The goal is to defer capital gains taxes on your profits from the sale.
Using a 1031 exchange is a great way to defer paying taxes on your profits from the sale of investment real estate. Knowing how to use one properly is complicated but doable with the right real estate professionals helping you.
To learn more about 1031 exchanges, contact a real estate professional.