If you are an investor or own a property and thinking about selling it to buy another one, it is helpful to know more about 1031 exchanges. A 1031 exchange allows you as an investment property owner to sell it and purchase a like-kind property while deferring capital gains tax.
A 1031 exchange derives its name from section 1031 of the US internal revenue code. It enables you to put off paying the capital gains tax when you sell an investment property and reinvest the funds in property of like-kind or equal or greater value within a specific timeframe.
However, the 1031 exchange has some rules, one of which is the presence of qualified intermediaries. According to section 1031, the proceeds from the sale of a property are taxable. Therefore, the proceeds from the property sale must be transferred to a qualified intermediary rather than the property’s seller. Then the qualified intermediary transfers it to the seller of the replacement property.
In simple words, a qualified intermediary is a company that facilitates the 1031 exchange by holding the proceeds of the property sale until they can be transferred to the replacement property’s seller. Also, the qualified intermediary should not have any other formal relationship with the parties involved.
Reasons to consider a 1031 exchange.
There are several reasons to consider 1031 properties or exchanges as an investor. They include:
- You wish to diversify your assets.
- You want a property with better return prospects.
- You are looking for a managed property to eliminate the obligations of managing ne yourself.
- You wish to consolidate several properties into one for estate planning.
- You intend to divide a single property into several assets.
- You want to reset the depreciation clock.
The tax deferral is the primary advantage you derive from a 1031 exchange. Contrary to selling one property and buying another, a 1031 exchange allows you to defer capital gains tax and leaves you with more capital for investment in the replacement property.
However, a 1031 exchange needs a higher minimum investment and a longer holding time, and that is why it is more popular with investors with higher net worth. Also, 1031 exchanges should be handled by professionals due to their complexities.
What is depreciation in 1031 exchanges?
Depreciation is one aspect that comes into play in the 1031 exchange. Depreciation refers to the percentage of the cost of an investment property written off annually, recognizing the impact of wear and tear. When selling an investment property, the IRS calculates capital gains tax based on the property’s net adjusted basis. That is the initial purchase price of the property plus capital improvements minus depreciation.
You have to recapture the depreciation if the sale proceeds are more than the depreciated value, which means that the depreciation amount will be included in your taxable income from the property sale. Note that the size of depreciation recaptured increases with time, so engaging in a 1031 exchange can help you avoid the increase in taxable income that the depreciation recapture would cause.
A 1031 exchange can be intricate, which is why you need professional help when doing it.