What You Should Know About 1031 Exchanges
Deborah Adeyanju, CFA, CFP®
For our clients, real estate is many things – shelter; a source of passive income; a potential legacy to leave for future generations. Real estate is also typically the biggest financial investment most people make.
Like-kind exchanges – authorized by Section 1031 of the U.S. tax code – allow sellers of investment property to delay paying capital gains taxes on their proceeds from sales of real estate. The tax break applies to both residential and commercial real estate. As the name implies, doing a like-kind exchange involves exchanging an asset for a substantially similar one. That means the property must be “of the same nature, character or class” as that sold.
You can defer paying capital gains tax on your sales proceeds indefinitely provided this condition and others including the two below are met:
no more than 45 days can pass between your sale of the first property and selection of a replacement; and
your purchase must close within 180 days of the sale of your initial property.
You must file Form 8824 with your tax return to report the exchange. It’s best to work with a tax professional experienced in 1031 exchanges as there are other specific requirements you have to meet in order to classify a transaction as a 1031 exchange.
Who might want to do a 1031 exchange
Like-kind exchanges are most attractive for taxpayers in a high bracket. Capital gains taxes on investments held for longer than one year are taxed at rates from 0%; 15%; and 20%.1 On top of these rates certain categories of taxpayers are subject to a surcharge of 3.8% on any investment gains.
Completing a 1031 exchange can allow you to avoid paying capital gains at the time of sale. That means you can use those funds towards other financial goals such as saving for retirement, starting a business, or growing your investment property portfolio.
What to watch out for with a 1031 exchange
Like-kind does not mean that the properties have to be exactly the same - say both single-family houses. But they do have to be similar in nature, for instance a single-family house and a two-family property. Or they could be commercial buildings of different classes.
Your exchange can be disallowed if you don’t roll over all your proceeds into the replacement property. They could also be disallowed if you don’t comply with all limitations, for instance, if you sell to or buy from a “related party” or convert the property to residential use before meeting specific holding requirements.
You don’t necessarily have to do an exchange to avoid paying capital gains tax at the time of your real estate sale. For property that is your primary residence, not investment property, you can take advantage of the existing exclusion from capital gains tax: $250,000 for singles and $500,000 for married couples filing jointly.
Alternatives to 1031 exchanges
Investing in an Opportunity Zone could be another route to deferring capital gains. The benefits of these investments are the potential to defer taxes on accumulated capital gains, or avoid paying taxes altogether if you meet holding period and other requirements. The most common way to do this is by investing through a fund, but these are typically only open to accredited investors. If you do qualify there’s a potential for a win-win. Since these funds are designed to channel investment dollars to distressed communities, at least in theory, they can present an opportunity to use your funds to drive impact. You still have to meet specific requirements including minimum holding periods.
Building generational wealth
1031 exchanges are a potentially powerful way to grow your wealth and create a legacy for future generations. Completing one can be complex though. It's best to work with your trusted tax and financial advisors to make sure you’re all squared away as far as documentation and compliance. Lastly, don’t let the tax tail wag the dog. It’s great to defer taxes,but that should not drive your decision to invest in a property.
1. Additionally, assets classified as collectibles have a flat capital gains tax rate of 28%.
About GRID
GRID 202 Partners is an African-American owned Registered Investment Adviser (RIA) specializing in fee-based, comprehensive financial and investment planning for individuals, couples, businesses and institutions. We serve successful, ambitious professionals and business owners, mission-driven organizations, and households that are committed both to creating wealth for themselves and future generations and to aligning their financial assets with their social impact objectives.