When you sell your business or investment real estate, capital gains taxes are payable on your profit and you will also have to pay additional taxes for depreciation recapture. These taxes substantially reduce what you have available to buy your next investment property. There is a very tax-friendly way to buy your next business or investment property called a “1031 exchange”.
What is a 1031 Exchange?
A 1031 exchange based on Section 1031 of the Internal Revenue Code. The process is simple – you close on selling your property, but you don’t physically receive your check at closing. Instead, the title company pays your net sale proceeds to a third party called a 1031 Intermediary, who has signed an exchange contract with you before closing. The Intermediary holds your money while you shop for new properties to buy. When you decide to buy new property (it can be one or more) the Intermediary uses your sales proceeds plus any new financing you obtain to buy the new property. This then completes your “exchange”.
Instead of reducing your available capital by tax payments, you are able to invest all of your sale proceeds to buy new investment property. But what about the taxes you owe from your sale? Payment of these taxes is deferred until you sell the new property (Property #2), whether that’s after one year or after twenty years. But what if when you sell Property #2 you decide to do another 1031 exchange to buy Property #3? You get to defer the taxes again until you sell Property #3! It’s possible for you to keep pushing your tax payment into the future indefinitely
until you decide to cash in and take the money.
Here are some basics to keep in mind for a 1031 exchange:
1. “Dirt for dirt”. Real estate must be sold, and real estate must be purchased. It doesn’t matter if you sell one kind of real estate (say vacant land) and buy a different kind of real estate (say an office or commercial building). Selling or buying an LLC interest or stock in a company owning real estate doesn’t qualify. Nor does selling or buying equipment.
2. To qualify for full tax deferral, you need to buy new property which costs (i) the amount of mortgage debt paid off when you sold your property, plus (ii) the amount of your net sale proceeds. If you spend less, then there will be some current tax you’ll have to pay.
3. Your property must be business or investment real estate. Don’t try to do an exchange with your home or your Florida condo – there are strict rules about personal use and this will give your tax accountant an ulcer.
4. There are two strict time rules – you have 45 days after your sale closes to give the Intermediary a list of the possible properties you might buy, and you must buy all your new property(s) within 180 days after your sale. You do not have to buy all the properties on your 45-day list, but any property you buy must be on that list.
At Hilger Hammond, we have decades of experience navigating the ins-and-outs of 1031 exchanges. Get started today by contacting Bob Cooper, Ben Hammond, or Jill Miller to help you with a 1031 exchange.