Section 1031 of the federal tax code allows real estate investors to defer paying capital gains taxes when selling an investment property, as long as they follow some basic rules. This is called the 1031 tax-free exchange.
The key to this exchange is that the proceeds from the sale must be reinvested into a “like-kind” property. This means a property of similar nature or purpose and within a specific time limit.
How does it work?
In a 1031 exchange, when an investor sells an investment property, instead of paying capital gains taxes on the profit from the real estate sale, they reinvest that money into a new property. The 1031 exchange allows investors to defer or reduce taxes if they follow the rules, including using a qualified intermediary to manage the transaction.
This exchange can be done multiple times, which allows real estate investors to grow their portfolio, while deferring taxes, theoretically, indefinitely.
Like-kind property
However, as stated at the outset, both properties must be like-kind properties. This means that the properties involved in the exchange must be of the same general type. For example, you could exchange an office building for a retail center, but not for personal property, like a car.
Often, investors want to use brokers or other real estate professionals, and they can with such exchanges as a qualified intermediary. This is a third party that manages the proceeds from the sale of the original property and uses them to buy the new one.
In fact, these agents are necessary because the seller cannot take possession of the funds during the process. After selling the original property, the investor has 45 days to identify potential replacement properties, but the replacement property must be purchased within 180 days.
The reason people use this process is because it defers capital gains taxes from real estate sales. Investors can then reinvest all the proceeds, which enables them to buy higher-value properties, diversify their holdings or consolidate their portfolio without the immediate tax hit. This strategy is especially useful in Florida, where property values have been on the rise.
Who should consider it?
Investors looking to grow their real estate portfolio, diversify their investments or those planning for long-term wealth transfer should consider using a 1031 exchange. It is also an excellent tool for estate planning because it allows for the transfer of assets to heirs with a stepped-up tax basis.
Investors can use 1031 exchanges to grow their portfolios and for several other purposes. By deferring capital gains taxes, investors can maximize their investment potential while ensuring more flexibility in managing their portfolio.