As an investor, you’re looking for every advantage to maximize your return. Investing in real estate is a great way to lower your investment risk and see positive returns over time.
However, when you’re ready to cash out on a property, you’ll be responsible for capital gains taxes. A 1031 exchange is a great way to defer those taxes and increase your investment portfolio. These exchanges aren’t just good for investors, but good for the overall economy.
You can consider this to be your civic duty. Read on to learn how to do a 1031 exchange.
1. Know What a 1031 Exchange Really Means
What does a 1031 exchange really mean? Does it mean you don’t have to pay taxes when you sell a real estate property? No!
The term 1031 exchange comes from section 1031 in the tax code that allows businesses to defer capital gains taxes when they replace a property for a “like-kind” property.
The idea is to allow businesses to grow without having a tax burden. A business might have to sell a warehouse it owns and get a larger warehouse.
Investors can leverage this by deferring capital gains taxes when they sell one property and purchase another.
Here are the details of a 1031 exchange explained. Read this to better understand what a 1031 exchange is and how it works.
2. Memorize the Deadlines
Would you like to know how to do a 1031 exchange that doesn’t fail? Learn the deadlines.
The IRS set out specific deadlines for businesses and investors to meet in order to defer taxes. They didn’t want to be in a situation where investors would hold-off on replacing the property or enjoy the profits without paying taxes.
Here’s what you need to know. As soon as you sell your investment property, you have 45 calendar days to find a replacement property. You have 180 days from the time of sale to close on the replacement property.
Tax Day can throw a wrench in your timing. If Tax Day happens sometime during the 180 day period, you have to close your sale by the time you have to pay taxes. That usually means April 15.
If you fail to meet any of these deadlines, you get the proceeds of the sale of the property and you can no longer qualify to defer the capital gains.
3. Surround Yourself With a Good Team
There will be a lot of moving parts in a 1031 exchange. You need to make sure that you surround yourself with a team of experts who can guide you through the transaction.
The first team member you need is a qualified intermediary. This is a company that will hold the proceeds from your sale and helps you with the paperwork to ensure a smooth transaction.
The IRS mandates that you use a qualified intermediary to complete a 1031 exchange.
You also need to work with real estate agents to find a buyer for your property and help you find a replacement property. You may need a lender or banker to help you finance your deal.
4. Have a Smart Strategy
A 1031 exchange isn’t something that you just decide to you. You have to be a smart investor to maximize its impact.
You need to have a long term strategy for 1031 exchanges. For example, you may sell your investment property because you want to downgrade properties.
Since the IRS requires that you exchange property for the same value or more, you’ll have to pay capital gains for the difference in value between the investment property and its replacement.
Are there ways to invest those funds elsewhere? You could use a Delaware Statutory Trust and invest the difference there.
No matter what you do, outline your investment goals and map out an investment strategy to get there.
5. Who Will Buy Your Replacement Property?
It can be difficult to think ahead when you’re trying to close on properties to meet the IRS deadlines. However, you need to be two steps ahead in investment properties.
You need to consider if you purchase a replacement property, who the likely buyer would be. You don’t want to be in a position where you purchased an investment property and no one wants to buy it later on.
6. Always Have a Plan B
Things happen in real estate transactions. Buyers might not be able to get the financing they need, or an inspection revealed a lot of property issues.
That being said, you need a plan B to make sure you can qualify for the 1031 exchange. You should have several replacement properties lined up just in case the first or second ones fall through.
That way, you’re not scrambling to find a replacement property at the last minute, which could lead to a bad investment.
7. Get Your Financing in Order Before You Do Anything
You don’t want to be the reason why a 1031 exchange fails. That’s why you need to make sure that you have your financing in order before you even begin the process.
You want to make sure that your replacement property allows for financing and your credit score is in good shape to get approved for a loan.
8. Stay up to Date on Rule Changes
Did you know that there were changes to 1031 exchanges in the Tax Cuts and Jobs Act of 2017? Prior to 2018, you would be able to exchange intellectual property, equipment, and many other items.
Now, you can only exchange real estate properties. As an investor, you need to stay up to date with this and future changes to the tax code.
How to Do a 1031 Exchange
A 1031 exchange is a great way to defer your taxes from capital gains when you sell a real estate property that’s used in business.
There’s a lot to learn when you’re just starting to discover how to do a 1031 exchange. You need to know the deadlines of the 1031 exchange. You have to have a replacement property lined up, and you need to have the right team around you before the deal closes.
Like any investment, it takes planning and strategy to be successful.
Do you want more investment tips? Check this blog often for articles that show you how to invest in real estate and more.