1031 Exchange and Capital Gains Tax

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October 10, 2023

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1031 Exchange

A 1031 exchange is a way to defer taxes on your capital gains from selling an investment property. When you sell an investment property and there is a profitable gain, you typically pay tax on the gain of the sale. A 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds into a similar property. (Tax deferred- not tax free).

Read the book Rich Dad Poor Dad as a great example of how to grow wealth through 1031 exchanges. A smart investment strategy is to start small (like a 1 bedroom condo) and over time you can exchange that property to a house, then to multifamily and then apartment complexes.

Most exchanges are completed through an intermediary. The intermediary provides expertise, guidance and most importantly assists in ensuring that the exchange complies with the IRS requirements. Send me a message and I can refer some great companies to you.

1031 Exchange Rules and Requirements

  • 1031 is for investment property only (not primary homes).  
  • It is an exchange for like-kind property. Like-kind property is property of the same nature, character or class.  Quality or grade does not matter. For example, a house is like-kind to land with no house. A house can be exchanged for another house, and an apartment complex can be exchanged for a strip center. etc
  • You have 45 days from the date you relinquish the property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary.  However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.
  • Replacement properties must be clearly described in the written identification.  This means a legal description, street address or distinguishable name.
  • You can designate multiple replacement properties. Suppose you had a mortgage of $500,000 on the old property, but your mortgage on the new property you receive in exchange is only $400,000. You have $100,000 of gain that is also classified as “boot,” and it will be taxed.
  • You must close on the replacement property within 180 days from the sale of the old property. Note that the two time periods run concurrently. That means you start counting when the sale of your property closes. If you designate replacement property exactly 45 days later, you’ll have 135 days left to close on the replacement property.

Homestead Exemption Sale/ Capital Gains Tax

Capital gains tax is a tax you pay on the profit from the sale of a property. Most likely any real estate you sell for a profit will be based on a long-term capital gain tax rate. Majority of tax filers are subject to 15% tax rate and the country’s highest earners are subject to a 20% rate. (subject to change).

If you are single and profit from the sale of your home is less than $250,000 you are excluded from paying capital gains tax. If you are married and file your taxes jointly, then the profit from the sale jumps to $500,000. However, you do have to meet specific requirements to claim this exclusion:

  • The home must be your primary residence.
  • You must have owned the home for at least two years.
  • You must have lived in the home for at least two of the past five years.

With these exclusions, it makes it fairly easy to avoid capital gains tax. There are a few exceptions and special circumstances that allow an owner to avoid capital gains tax even if the above requirements aren’t met.

For example, you can treat part of your profit as tax-free even if you don’t pass the two-out-of-five-years tests. A reduced exclusion is available if you sell your house before passing those tests because of a change of employment, or a change of health, or because of other unforeseen circumstances, such as a divorce or multiple births from a single pregnancy. So if you need to move to a bigger place to find room for the triplets, the law won’t hold it against you.

Note: A reduced exclusion does NOT mean you can exclude only a portion of your profit. It means you get less than the full $250,000/$500,000 exclusion. For example, if a married couple owned and lived in their home for one year before selling it, they could exclude up to $250,000 of profit (one-half of the $500,000 because they owned and lived in the home for only one-half of the required two years).

Have a question? Email me!

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