Using the 1031 Exchange to Defer Paying Taxes

Are you thinking about selling your investment property, but you’d rather not give the government a good chunk of your profit in taxes? Then you’ll want to consider doing a 1031 Exchange. You can use the 1031 Exchange to defer both depreciation recapture tax and capital gains tax. It requires using the proceeds of your investment property sale to buy another investment property.

And there are some very particular rules that must be followed to make sure your 1031 Exchange is valid, and will be accepted by the IRS.

First, the property that you are buying must be of Like Kind to the property being sold.

While this may sound restrictive, it’s really not. In fact, most income-producing properties are considered like kind and eligible for a 1031 Exchange.

So, a shopping center can be exchanged for an apartment building and an office building can be exchanged for a hotel. The key is that it has to be one income producing property in exchange for another.

Second, the replacement property should be of equal or greater value to the one being sold. At Prosperity CRE we have a strategy called Cascading Up, where we look to 1031 exchange into larger properties with greater potential cash flow and potential for growing the value of the property. Buying properties of greater value is consistent with this approach.

The third requirement is that the replacement property must be identified within 45 days of the date you sell the first property. In a highly competitive real estate market, this is where it can get a little tricky. Once you sell your property you have a very narrow window of just 45 days to identify your replacement property. Now the IRS Code, thankfully allows you to identify up to 3 properties as potential replacement properties, and you only need to close on one of them.

The fourth requirement is that the property being purchased must be bought within 180 days of the date the first property is sold. If you’re able to identify one or more potential replacement properties within 45 days, it usually isn’t a problem to close on one of them within 180 days.

When contemplating a 1031 exchange, be sure to use a qualified intermediary, also known as a 1031 exchange accommodator, to facilitate the exchange.

The money from the sale of the first property can’t touch your hands or your bank account. The 1031 exchange must go through the exchange accommodator to be valid.

Remember, the 1031 Exchange is a tool to defer paying taxes. But you shouldn’t rush to buy a property that doesn’t make financial sense, just to defer taxes on the property you’re selling. So, if you’re not able to identify a replacement property that meets your financial objectives, it may be better to pay the taxes and avoid buying a property that’s not going to perform.

And be sure to seek professional advice before starting a 1031 exchange. As long as you follow the rules and pay attention to the timeline, you’ll be well on your way to executing your exchange, and deferring your taxes.

We hope you found this article helpful. If you’d like to learn more about Prosperity CRE’s approach to real estate investing to generate ongoing cash flow and building long term wealth, you can receive a complimentary copy of our real estate investment book by clicking the link below.

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