Capital gains taxes can destroy any real estate investor’s chance of making money in the long run. In fact, the U.S. Internal Revenue Service (IRS) estimates that capital gains taxes cost taxpayers nearly $100 billion each year, and they’re only getting worse as time goes on. If you’re thinking about starting a real estate investing business, it’s absolutely vital that you know everything you can about Section 1031 of the U.S. Internal Revenue Service’s tax code.
What is Section 1031 of the U.S. Internal Revenue Service Code About?
Section 1031 of the U.S. Internal Revenue Service (IRS) tax code is also known as a like-kind exchange—which means that you can exchange one property for another without paying capital gains taxes on any appreciation. If you want to purchase a new property but don’t have enough cash on hand, like-kind exchanges allow you to defer capital gains and reinvest these savings elsewhere in your real estate portfolio.
With that being said, exchanging properties under Section 1031 isn’t easy—there are strict rules regarding eligibility and timing. If you own multiple properties that appreciate at different rates over time, it might be better to sell one property rather than trying to time your sale with an appropriate replacement property. If you are unsure about executing a 1031 exchange, here is one question you may wish to ask yourself: Do I Have Multiple Properties?
The first step towards figuring out whether or not your situation qualifies for a like-kind exchange is determining whether or not you actually own more than one property. If you’re actively involved in real estate investing, then most likely, the answer is yes. This doesn’t mean that all investors should take advantage of Section 1031 right away—but it does mean that most investors would benefit from learning about how 1031 works and what they need to do to make sure they get their fair share of tax benefits while minimizing their risk.
How Does the Exchange Work
As per the IRS explains Section 1031 of its tax code, there won’t be any gain or loss recognized on property transfer from an individual to an entity, if the property is solely exchanged for like-kind property which is to be held either for productive use in a trade or business or for investment. There are some restrictions and stipulations around qualifying transactions, but you can learn more about them at the IRS’s website.
Simply put, though, you exchange your real estate investment properties with other types of real estate—either personal or commercial—and not for cash. This way you can defer paying capital gains taxes because technically, there was no gain when transferring your old properties into new ones. You essentially swap properties in hopes that future appreciation will make up any lost equity when selling your old properties in years past. However, you have to complete all steps of Section 1031 before December 31st of that year, or else you’ll have to pay capital gains taxes.
For example, say you purchased two properties three years ago for $200,000 each. Today, they are worth $300,000 apiece. If you sold them both today without using Section 1031, then you would owe approximately $11,800 in capital gains taxes (based on 2018 rates). But if, instead, you applied these principles through the exchange, then legally, you never made any profit, so there were no taxes due during sale—you simply swapped one set of properties for another set of similar value under similar conditions.
By taking advantage of the exchange, real estate investors avoid paying capital gains and potentially build wealth through investing in real estate. Buying and selling property under Section 1031 of the IRS code has several benefits, such as: Avoiding Capital Gains Taxes: The U.S. tax code allows you to defer paying capital gains taxes when you buy and sell properties over a period of time—but only if you use the IRS exchange.
By now, you should know why the exchange is important to real estate investors, and how to use it as part of your investing strategy. If you ever find yourself sitting on capital gains from selling an investment property, keep in mind that Section 1031 of the U.S. Internal Revenue Service’s tax code could save you money and be an effective way to reinvest those gains into more profitable real estate ventures.