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Know the Rules: 1031 Exchanges Explained

Know the Rules: 1031 Exchanges Explained

If you’re the owner of an investment property, you may have thought about acquiring another property as a way to diversify assets. However, the thought of paying taxes on multiple properties may be holding you back.

But did you know that you defer your taxes by purchasing a new property? It’s possible, but only if you do a 1031 exchange.

What’s a 1031 and how can it benefit you? Here are 1031 exchanges explained. 

What Is a 1031 Exchange?

A 1031 exchange is a swap of a real estate investment property for another similar property, alowing for deferrable capital gain taxes. When this is done, it’s considered a like kind exchange, specifically a like kind property. Like kind means the new investment property is the same type or “like kind” as the former property.

The benefit of a 1031 exchange transaction is that it’s a tax break. You can sell a property that you’ve owned (either for business or investment purposes) and swap it for a new property purchased for the same purpose. This allows you to defer capital gain taxes, essentially rolling them onto the new property, and deferring the tax until the new property is sold. 

The name of a 1031 exchange comes from Section 1031 of the U.S. Internal Revenue Code (IRC). 

What Are Capital Gain Taxes?

A capital gains tax is a tax levied on the profit made when an investment sells. 

The 2022 tax rates for long-term capital gains are either 0%, 15%, or 20%, depending on the filing status and income of the tax filer. For most individuals, the capital gains tax will be 15%.

However, if you make over $459,750 as a single filer, $488,500 as the head of a household, $517,200 as married filing jointly, or over $258,600 as married filing separately, your capital gains tax will increase to 20%. 

Rules for 1031 Exchanges Explained

Prior to the Tax Cuts and Job Act (TCJA) in 2017, some exchanges of personal property were eligible for a 1031 exchange. However, now only real property or real estate qualifies for a 1031 exchange.

Since finding someone to swap property with can be difficult, many exchanges are delayed exchanges. In a delayed exchange, a qualified intermediary acts as a middleman.

They hold the cash after you sell your property and use it to buy the new property. Directly receiving the cash yourself will violate Section 1031. 

Within 45 days of the sale of your first property, you must designate a replacement property in writing to your intermediary. Per the IRS, you can designate up to 3 properties, but you must close on one of them. This is the 45-day rule.

Within 180 days of selling your old property, you must close on the new property. This is the 180-day rule. If there is leftover cash after the intermediary acquires the new property it will be returned to you at the end of 180 days. 

This is the boot, and it’s taxed as partial sales proceeds from your property sale.

Let Kerr Manage Your Rental Property

Of course, this is just a quick briefing on how 1031s work. Every situation is different, so don’t hesitate to contact a tax professional and ask to have 1031 exchanges explained to you. 

A 1031 exchange can help you receive the investment property you have always desired, but you still have the headache of managing it - unless you use Kerr Properties. Let us manage your Portland rental property.

Get a free rental analysis here.