When you sell real estate, you generally have to pay tax on the gain at the time of sale. Section 1031 or a “Like-kind exchange” provides an exception and allows investors in real estate to postpone paying taxes on the gain if the proceeds are reinvested in a similar property as part of a qualifying like-kind exchange. Simply put, you are investing in your future with tax deferred income.
To qualify as a "like-kind exchange", you must meet the following criteria:
- The property has to be for use in a trade or business, rental, or held for investment. This means you cannot sell a personal residential property.
- The value of the replacement property (new property) must be greater than the relinquished property (old property).
- Within 45 days of selling the relinquished property, you need to identify a replacement property.
- The deal must close on the replacement property within 180 days from selling the relinquished property.
- A qualified intermediary must be hired to handle the entire 1031 exchange process.
Other key notes:
- You can exchange a single property into multiple properties or vice versa.
- You can use 1031 to acquire co-owned or managed property (Tenancy in Common).
- Foreign properties are eligible (foreign tax treaty may apply). You may be able to exchange foreign property for another foreign property, however exchanging a domestic property for a foreign property is prohibited.
- House flipping and 1031 exchanges do not mix. Properties held primarily for sale in the ordinary course of business do not count as property held for investment.
A section 1031 exchange helps savvy investors sell old properties and exchange for newer and higher valued properties, potentially reaping larger profits, if executed properly.
There are other great tax saving strategies that real estate investors can take advantage of every year. A Qualified Opportunity Zone (QOZ) and Qualified Business Income deduction (QBI) are also useful strategies to reduce your overall tax liability, while building wealth as a real estate investor. That being said, it is important to work with a tax strategist who understands real estate and can help you arrange your affairs to make sure you are minimizing taxes and maximizing income and wealth.
All of the above items are very complex. Please consult your tax advisor before engaging in any transaction.