If you own an investment property and are not a fan of paying additional taxes, the 1031 exchange could be a strategy for you. 1031 exchanges are named for Section 1031 of U.S. Internal Revenue Code that allows real estate investors to defer paying taxes from the sale of their investment property. It is important to realize this does not make the sale tax-free. It makes it a tax deferral and a 1031 exchange can be tricky to implement. There are a few caveats and moving parts when applying the 1031 exchange, so it is important to go through all the proper steps to avoid any future issues.
First, the proceeds from the sale of the property will need to be held by a qualified intermediary and not the individual person. There are many companies that specialize in 1031 exchange transactions. How then are the actual capital gains calculated? While your primary home will have either $250,000 (if single) or $500,000 (if married) exempt from capital gains taxes, this does not apply to investment properties. The amount taxable would be calculated on a net adjusted basis. This is the original price paid for the property plus improvements minus depreciation. Also, the new property must be a “like kind property.” This term is used broadly and does not necessarily mean similar properties.
After funds are in the intermediary, the future investment property or properties must be identified within 45 days of sale. Also, the new property transaction must be fully completed within day 180. If there is additional cash from the replacement, it is known as “boot” and this can be taxed as gains. This can also apply to new loans if the new loan is less than the original one, which can cause the new property to be valued as less.
After the passage of the new Tax Cuts and Jobs Act (TCJA) under the Trump administration in 2017, some exchanges of property like licenses, aircraft, and equipment are no longer eligible for a 1031 and must now be only real property. However, having a property in mind and wanting to continue with investment management may not be the only scenario where these tax programs can apply. What also came about from the TCJA was the creation of what is known as “qualified opportunity zones.” The program was created to provide for the revitalization of certain areas through the reinvestment of capital gains into low-income neighborhoods. These investments build up those areas by incentivizing investments from investors for the deferral of previous capital gains. There are various companies that manage these funds and you would need to complete your due diligence to find one who fits your needs. The way they work is that the investor is able to defer recognizing the original gain until December 31, 2026, and receive at least a 10% reduction in gain from tax liability if held for at least 5 years, and up to 15% if held for 7 years. The investment also has tax-free appreciation in QOF if held for at least 10 years. There are many ways these gains can be invested through these various fund companies, as long as it is done within 180 days of the initial capital gains transaction.
1031 exchanges and opportunity zone investing are just a few of the many ways you can help reduce your tax liability throughout the year and efficiently provide proactive planning. If you are interested in learning more, please reach out to us at 678-905-4450 or schedule an appointment online by going to wiserinvestor.com/contact-us.
Matthews Barnett, CFP®, ChFC®, CLU®
Financial Planning Specialist