If you're a property owner or investor, you may have heard of 1031 exchanges. These offer a unique way to defer capital gains taxes on the sale of investment or personal property. In this blog, we will discuss what 1031 exchanges are, how they work, and some of the benefits they offer. If you're looking to buy Chapel Hill homes for sale or Raleigh real estate, it's important to understand how 1031 exchanges can help you save money on your purchase!
What are 1031 Exchanges?
A 1031 exchange occurs when an investor takes advantage of the Section–you guessed it–1031 of the Internal Revenue Code (IRC) that governs swapping one investment property for a different investment property while deferring taxes on capital gains.
The basic rules associated with a 1031 exchange on Chapel Hill homes for sale or Raleigh real estate require the investor to:
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Purchase a "like-kind" property of equal or greater value within 180 days of selling the original property.
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Use a qualified intermediary (QI) to facilitate the exchange.
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Reinvest all of the proceeds from the sale into the new property.
What is meant by "like-kind"?
The most important thing to remember is that in order for the exchange to be valid, the property being purchased must be "like-kind." This means that it must be held for investment or used in a trade or business. The rules regarding the types of property that qualify for a 1031 exchange state:
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Both properties must be located in the United States.
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Both properties must be of the "same nature, character, or class," meaning that new land purchased in exchange for previous real estate must be used for the same purpose (such as vacant land coded as residential in exchange for an existing rental home).
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"Property" refers to real estate, such as Chapel Hill homes for sale or Raleigh real estate, not other belongings. An exchange does not apply to trades of inventory, stocks, bonds, securities, debt, certificates of trust, or partnership interests.
Why must I work with a QI?
When you work with a Qualified Intermediary (QI)--also sometimes referred to as an Accommodator–they hold the proceeds of the sale in escrow until the replacement property is identified and purchased, which allows you to avoid capital gain taxes on the profit from your sale as you wait to invest them entirely in the new property. Note that the QI must be a third party for the exchange to be valid; it cannot be you, your agent, mortgage broker, attorney, accountant, etc.
Why do I have to reinvest all of the proceeds from my sale into the new property?
The simple answer is that if you don't, you'll have to promptly pay taxes on the amount of money that you didn't reinvest in Chapel Hill homes for sale or Raleigh real estate. In order to avoid this, it's important to reinvest all the proceeds from the sale of your current investment property into your new investment property. By reinvesting all the money earned, you defer the need to pay capital gains taxes until you sell your last investment property and pocket the proceeds.
How do 1031 exchanges work?
Given it is rare to find an investor willing to do a full swap on Chapel Hill homes for sale or Raleigh real estate, where you exchange your properties, most 1031 exchanges are delayed. As part of the delayed exchange, you use the services of the QI as discussed previously. When doing a delayed exchange, there are two deadlines: 45 days and 180 days.
At the 45-day mark, you must inform your QI in writing of potential properties you are actively considering for the "swap." Note that notice to anyone other than your QI is insufficient, so simply notifying your real estate agent, attorney, or accountant is not going to cut it.
By the 180-day mark, you must obtain the new property. However, if your income tax return (with allowed extensions) is due prior to the 180-day mark, the income tax due date is the date by which you must receive the new property. The new property must be the same or distinctly similar to the property or properties you identified at the 45-day mark.
Note that both the 45- and 180-day limits apply with reverse exchanges as well, which is when you buy the new property before selling the old one.
The taxes are deferred, but how does that work?
When a like-kind 1031 exchange on Chapel Hill homes for sale or Raleigh real estate is successfully completed, you won't owe taxes that year, but this does not mean you won't ever owe the taxes on the property exchange. The taxes have simply been deferred until you decide to sell the received property. When you eventually sell the replacement property for profit rather than another swap, you will be taxed on both the deferred gains and the additional gains on the property (like an increase in sale price versus the price originally paid).
Further, if you have profit left over after buying the new property, you will receive it in cash at the end of the 180-day window. This profit is known as "the boot" and will be taxed as a capital gain on partial sales proceeds. The boot also applies to debt on the original property. If you owe a mortgage at a higher amount than what you will pay on the new property, any difference in amounts counts as a "boot" on your annual income tax.
Note that there are very specific rules for swaps on vacation, secondary, and primary residences, which generally block these from being eligible for 1031 exchanges. However, if you have rented the property to tenants for six months to a year or more, you can exchange it under Section 1031. However, if the property has not been used by tenants, it can be disqualified.
How do I report the 1031 exchange on my taxes?
You must submit an 8824 Form, which requires you to include details about the properties exchanged, including a description of both properties, the actual dates of the 45- and 180-day marks, relationships between the parties involved, the value of both properties, gains or losses on property that was not considered "like-kind" as part of the exchange, cash exchanged, and the adjusted basis of the property relinquished for realized gain.
If you completed more than one exchange, you’re required to submit a different 8824 Form for each exchange. Timing also plays a part in the submission of the 8824 Form. Suppose you’re involved in an exchange that will not be completed in time for the deadline for filing. In that case, you should file for an extension with Form 4868. The reason that form exists is because if you file your return before the exchange is complete, capital gains from the exchange would not be deferred. Finally, depending on your location, you may be required to report the exchange on your state tax return, and the calculus gets more complicated when the properties exchanged are in two different states.
What benefits do 1031 exchanges offer?
Now that we've answered some of the basic questions, let's take a look at some of the benefits of completing a 1031 exchange on Chapel Hill homes for sale or Raleigh real estate.
First and foremost, a successful 1031 exchange allows you to defer capital gain taxes on the profit of your sale. This can be a significant amount of money, particularly if you've owned the property for a long time or it has appreciated significantly in value. By deferring the taxes, you can reinvest that money into another property and continue to grow your investment portfolio.
In addition, a successful exchange allows you to "step up" the basis of your new property. The basis is essentially the cost of the property for tax purposes. When you sell a property, your capital gain is calculated by subtracting your basis from the sale price. This "stepped up" basis can be a significant advantage if you plan on holding the property for a long time or if it appreciates significantly in value.
Additionally, 1031 exchanges are excellent for estate planning since they can help you pass on property to your heirs with a greatly reduced tax burden. Since your tax liability ends when you pass away, the beneficiaries who receive your property after your death will not have to pay the deferred taxes and instead be on the hook for the current market-rate value.
As you can see, there are a number of benefits to completing a successful exchange. While it's not right for everyone, it's definitely something to consider if you're thinking about selling your investment property.
Learn more about 1031 exchanges for Chapel Hill real estate
Chapel Hill and Raleigh offer great opportunities for real estate investors, so if you want to learn more about how a 1031 exchange could save you money on your taxes, contact Welcome Home 919 Realty Group for assistance.
