Q. What is a 1031 Exchange?
A. A 1031 Exchange is a relatively simple addition to the process of selling an investment property that allows an investor to completely defer state and federal capital gains taxes on a property he or she sells by buying another property of equal or greater value. The replacement property must be held for investment, however.
The properties need not be identical since under the tax laws all real estate is considered to be of like-kind. In other words, a single-family rental can be sold and the proceeds exchanged into some other type of rental property, vacant land or property used in connection with the taxpayer’s trade or business.
Q. How does it work?
A. The seller must first find and retain a qualified intermediary, the company that will hold the net proceeds from the sale of his or her existing property in a special type of escrow during the exchange period. There are two key deadlines that apply to all 1031 Exchanges. First, the seller must identify a new property to buy within 45 days after closing on the sale of his or her existing property. Second, he or she must close on the purchase of the new property within 180 days.
Q. What are the advantages this approach?
A. Investors who uses the 1031 Exchange will be able to invest more money into the next purchase and not pay capital gains taxes until the second property is sold. This allows for wealth building and it acts as an interest free loan from Uncle Sam!
Q. Why is that preferable, since the taxes must be paid eventually when the second property is sold?
A. Although the general inflation rate is low, the capital gains taxes will be less in real, inflation-adjusted dollars. Example: If you would have owed $50,000 in capital gains on the first property, that $50,000 could cost several percentage points less in real dollars, depending on how long the tax is deferred. It is also a good strategy if it appears that the leadership in Washington is likely to lower the capital gains tax rate, depending on how the new law is written.
Q. Why is a 1031 Exchange a good strategy in Boulder?
A. In an environment in which property is appreciating rapidly, it's especially good to have as much investment capital as possible. It gives the savvy investor more leeway in a hot market.
Q. Is there a limit to how many properties can be bought and sold in this way?
A. Generally there are no limits. However, issues relating to whether a property was really “held for investment” or is considered a “dealer property” could be present when someone does successive exchanges (i.e., a chain of exchanges). On the other hand, someone who has a portfolio of rentals can do a separate exchange each time they sell a property.
Q. Must the two properties be in the same city?
A. No, they must be located in the USA and properties that qualify as being held for investment.
Q. When should an investor not use a 1031?
A. An investor should always discuss his or her plans with a CPA or other tax advisor. Sometimes an investor has loss carry-forwards that can be utilized to offset the gain on a sale. Sometimes the seller is a short-term investor who may want to take cash immediately, which requires paying capital gains.
To see if a 1031 Exchange is right for you please reach out to Rich Levy, our preferred vendor.
1031 Solutions, LLC
4450 Arapahoe Ave., Suite 100
Boulder, Colorado 80303