Imagine you own a property and decide to sell it, but now you have to share the profits with the government through taxation. Sounds awful, right? It may shrink your margins, especially when you aspire to enter the real estate industry to make suitable investments. Have no fear though, there’s a very popular loophole called a like kind exchange, or 1031 exchange. It’s a great way to defer taxes and maintain profits until you’re ready to exit. However, to leverage this tool, you have to follow specific rules. Simply put, this IRS code allows you to defer paying taxes on capital gain if you reinvest your money into another real estate asset within a certain period of selling the previous one. So let’s dig into this code and get an understanding of how it works!
Why do Real Estate Investors Need 1031 Exchange?
A like-kind exchange is crucial for real estate investors to retain profit gain without paying taxes. However, the condition is that you must reinvest the capital you gain from selling a property to another within a certain period. It allows investors to defer taxes on capital gain and reinvest to make a good portfolio. Nevertheless, it would help if you considered a few things to attain its perks.
Invest in Like-kind Properties
Investing in like-kind properties is one of the critical criteria for acquiring a like kind exchange’s benefits. While reinvesting, you should remember that this tool is only valid if the money is reinvested in like-kind property. This raises the question- what counts under like-kind properties?
This implies that both the properties sold and bought should be similar, if not of the same quality. To your benefit, in real estate, almost all the properties are like-kind assets. This suggests you buy a residential property for a commercial space. Whether it’s an apartment, office complex, or vacant land, they all come under like-kind assets.
However, the purpose of buying matters a lot. According to the law, property bought must be used for business or investment. If a residential suite is bought with the purpose of resale, it does not qualify.
Timeline Requirements
Every good opportunity comes with a deadline. Similarly, the like-kind exchange is also a time-sensitive process. There are two strict timelines real estate investors must adhere to to attain its benefits:
The first is 45 days, according to which you have to choose the property for reinvestment within 45 days of selling the original one. You can make a list of up to 3 properties and submit them to the qualified intermediary. Remember that you can not directly invest the money yourself.
The second is 180 days. While you have to identify potential properties to reinvest within 45 days, you must close on the final purchase within 180 days. You may be subject to tax penalties if the period exceeds this deadline. Also, the two timelines run parallel. This implies that your 180-day timeline begins when you sell the original property.
Boot: Everything You Should Know
Imagine you sell a property at an X rate. Further, you invest the capital in a comparatively inexpensive property and save a portion. This leftover money is known as boot. The boot is subject to non-deferrable capital gains taxes. So, to prevent paying these taxes, one should choose a property with equal or more excellent value than the original sale price. All the proceeds must be reinvested; otherwise, a like kind exchange won’t be so helpful.
Future of Exchange Tools
In the past few years, rules around like kind exchange have evolved from when jobs and tax restricted this provision to real property only to now, where real estate properties qualify only. This is an ongoing development, and the law will experience many such developments in the future. However, its significant role in investing and the economy makes it a crucial topic for debate.
Conclusion
In summary, like-kind exchanges are potent tools for US real estate investors. They allow them to retain profits and multiply wealth while diversifying their portfolios. Moreover, they enable investors to upgrade to high-value properties and prepare for the future, ensuring sufficient cash flow. The flexibility and financial freedom it provides make it an integral part of investors’ toolkits.
