Introduction:
What exactly is a 1031 exchange? Is this one of the ways that I do not need to pay my capital gains tax? Find out the answer here!
Investing in Commercial Real Estate, Multifamily Apartments and Other Assets
Commercial real estate is becoming increasingly popular among investors trying to diversify their portfolios away from stocks, bonds, and other assets. Some real estate investors will test the waters by purchasing a small single-family rental property, duplex, or triplex home they will manage themselves. Others, particularly those who wish to be completely hands-off with their investments, will instead invest alongside a qualified sponsor who will manage the investment on their behalf.
In either scenario, it is customary for investors to begin with multifamily commercial real estate investments. Most people have lived in an apartment or owned their own home at some point in their lives, so multifamily buildings are familiar. As a result, multifamily tends to appeal to the masses compared to other property kinds.
Investing in real estate provides major tax benefits. For example, owners of investment properties can depreciate a portion of their acquisition expenses, lowering taxable income without incurring further costs. However, failing to arrange for the tax implications of a sale might result in massive capital gains and depreciation recapture payments to the IRS. Fortunately, options are available to defer these tax costs when you sell an investment property, such as the 1031 like-kind exchange. As a result, we’ll utilize this article to explain how a 1031 exchange works.
We’ll go through the following subjects in particular:
- What exactly is a 1031 Exchange?
- What Is the Process of a 1031 Exchange?
- Last Thoughts
What exactly is a 1031 Exchange?
When you sell an investment property for more than you paid, you must usually pay capital gains tax. For example, suppose you paid $1,000,000 for an apartment building and sold it for $1,500,000 several years later. In this case, you would have a $500,000 capital gain (ignoring transaction costs). This would be taxed at 0%, 15%, or 20%, depending on your income bracket.
Furthermore, the IRS permits owners of investment properties to depreciate the property over a specified period (27.5 years for residential and 39 years for commercial real estate). While this reduces taxable income while the property is held, the IRS snatches this benefit back when the property is sold through a process known as depreciation recapture. Continuing with the previous scenario, suppose you claimed $100,000 in depreciation while operating the property. The IRS would levy a depreciation recapture tax of 25% at the time of sale, amounting to an additional $25,000 in taxes.
Selling an investment property might result in a substantial tax burden. Fortunately, the IRS allows investors to defer (or postpone) paying these taxes. A like-kind exchange, often known as a 1031 exchange, is permitted under Section 1031 of the Internal Revenue Code. This 1031 exchange allows owners to sell an investment property and roll the 1) gains and 2) accumulated depreciation into a new property while delaying taxes. In other words, when you complete a 1031 exchange, you do not have to pay capital gains or depreciation recapture.
Recognizing the Benefits of “Boot”
Investors should comprehend the notion of “boot” before pursuing a 1031 exchange. You are considered to have a boot if you do not roll all your proceeds from selling a property into purchasing a new one. Assume you receive $500,000 in cash from the sale of a property. If you keep $100,000 and reinvest $400,000, the $100,000 qualifies as boot, and you must pay capital gains tax on it.
Furthermore, investors must detect boot when their new mortgage is less than their old one. Assume you have a $250,000 mortgage when you sell the last house. The new home is then purchased with a $200,000 mortgage. In this case, you would have $50,000 in mortgage reduction proceeds, necessitating capital gains tax.
What Is the Process of a 1031 Exchange?
A 1031 exchange involves strict adherence to IRS regulations and should not be done without professional tax assistance. Having stated that, here are the basic procedures for a 1031 exchange:
Step 1: Locate the property you intend to sell.
Before transferring property, you must first determine what you want to sell. When determining the property you intend to sell, items to consider include your taxable base, present mortgage, and market value.
Step 2: Retain a Qualified Intermediary.
The IRS requires that you not handle the 1031 exchange yourself. Rather, a qualified intermediary – or 1031 exchange accommodator – sells the property, collects the money, holds those proceeds in escrow, and then purchases the new property on your behalf.
Qualified intermediaries should handle all components of a 1031 exchange. Failure to strictly follow all Section 1031 regulations may result in capital gains recognition. As a result, investors should carefully screen potentially qualified intermediaries to verify they have a track record of successful 1031 transactions.
Step 3: Sell the Home.
Once you have identified them, you will sign a contract with the qualified intermediary to conduct the 1031 exchange on your behalf. Intermediaries in this role will sell your property, collect the proceeds, and deposit them in an escrow account.
Step 4: Find a replacement property within 45 days of the sale.
You have 45 days beginning on the settlement date of your sale to find up to three potential replacement homes to purchase with your sales proceeds. During the 45-day “identifying phase,” you must give specific details of potential properties to your qualified intermediary.
It’s worth noting that you don’t have to buy all of these properties – just one. However, by allowing you to designate three potential properties, the IRS gives you some wiggle room in case your favorite property comes off the market before you can buy it.
Step 5: Complete the new home purchase within 180 days of the sale.
You must close on the purchase of the replacement property within 180 days of selling the previous one. Because closing delays are unavoidable, you’ll want to give yourself a cushion to guarantee you don’t miss this critical deadline. Do not arrange your closing on Day 179, as a delay will almost certainly necessitate the recognition of capital gains on your sale.
Step 6: File IRS Form 8824 and Recognize Taxable Gain on Boot as Required.
Form 8824, Like-Kind Exchanges, must be filed with the IRS to report a 1031 exchange. This form reports your sale and deferred gains and must be filed in the tax year in which the original property was sold.
You must also include any taxable gain on footwear as part of this filing. As previously stated, receiving cash or a mortgage decrease is considered receiving boot, and you must pay the related capital gains tax.
While owning an investment property provides excellent tax benefits, new investors must also plan to sell those properties. Fortunately, several tax options, such as 1031 exchanges, can assist you throughout tax season.
We’d love to discuss other real estate investing opportunities for your specific scenario! Send us an email, and we’ll set up a meeting to discuss various passive real estate investment alternatives and the tax consequences.
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