Can You Do a 1031 Exchange on an Investment Property?
Posted by: John Crow
Date: February 25, 2021
Posted by: John Crow
Date: February 25, 2021
As a property owner, you’re tasked with considering both present circumstances and future outcomes. How can you ensure that your rental or investment property is profitable, even when it’s time to sell? When it comes to rental properties and 1031 exchanges, there’s a wealth of information you may not know.
In our Ultimate Guide to Selling Rental Property, you’ll find a basic overview of why you’d want to sell your rental property and how you can get started. While timing plays a role in your decision, having realistic expectations and a working knowledge of tax rules is important.
In this post, you’ll learn more about the ins and outs of 1031 exchange properties. Once you’re aware of the benefits, drawbacks, and personal considerations, you can make an informed decision based on your own financial situation and unique tax burden.
A “1031 Exhange” refers to Section 1031 of the Internal Revenue Service (IRS) code in the United States. Section 1031 describes “Like-Kind Exchanges” that apply to the world of investment real estate.
A like-kind exchange simply means that an owner is eligible to sell a property and invest the money back into a similar property. There are important rules and definitions to follow, including the fact that you must be recognizing a gain, rather than claiming a loss. Additionally, like-kind rules apply only to similar properties within the United States and are not eligible on international rental properties.
For many investors, the most beneficial result of Section 1031 is the ability to defer taxes on capital gains. We’ll take a closer look at more of these tax and financial considerations later.
In short, the answer to whether you can do a 1031 exchange on your rental property is yes! Section 1031 of the IRS code doesn’t include specific language for landlords. While that’s the case, this solution can be a saving grace for many investors who self-manage their properties.
There are many reasons you might consider a 1031 rental property exchange. These reasons might include:
Additionally, a 1031 or like-kind exchange may prove helpful if you’ve made a previous bad investment. In an ever-changing market, real estate valuation ebbs and flows. To an investor, the constant shifts can either be profitable or can significantly cut into individual assets.
Even if you were not the original purchaser or owner of a property, selling means that you are the one responsible for any capital gains taxes. This is an important consideration for rental property owners who typically do not keep primary residence in their managed properties.
If you are a landlord or property owner, you should consider options from every angle. Occasionally, what sounds perfect in the short-term can prove disastrous down the line. As always, involving real estate and tax professionals can help you weigh the pros and cons.
Savvy real estate investors will understand and anticipate the continuous cycle of questions and discoveries that impact success. One of these vital questions involves whether to pay off the mortgage of a rental property in the first place.
Before you proposition yourself for a 1031 like-kind exchange, you may consider how much (if any) you still owe on the original loan for the property. Do any of the following scenarios apply to you?
Before you make a decision, take a look at your goals for what you want to earn on the property in an ideal situation. Paying off a rental property mortgage may be contingent on several other factors, including where you stand financially with your primary residence.
As you consider rules for a 1031 exchange rental property, the math can get complicated quickly. There are several tools and calculators available for understanding your deferred gain on a real estate investment. Be prepared to provide extremely specific numbers and values to get the best estimate.
As you approach the time to sell, be prepared for taxes from all angles. There are 4 primary avenues through which taxes on gains may take place. These include:
For many real estate investors, high taxes are a driving factor in deciding to go the 1031 exchange route. Although taxes don’t always imply loss, hefty profit cuts change the overall results of a sale.
Put simply, capital gains are calculated by taking your basis and subtracting it from the sale price. A basis is composed of:
By understanding the above guidelines, you’ll be able to use an equation to determine the sum that is eligible for taxation. Keep in mind that using a 1031 exchange creates deferred capital gain.
A 1031 exchange doesn’t eliminate the tax, but it does create a system in which investors can delay the tax while through a property trade-off. It’s important to mention that you could forfeit some notable write-offs by completing an exchange.
Simple calculations may be able to give you a preview of your expected deferred gain. While that’s the case, it’s still important to involve a professional who is well-versed in the mathematics of 1031 rental property exchanges. This ensures that you have the most accurate information possible.
Completing a 1031 exchange includes several critical steps. First, you need to research options and develop a plan for your own financial situation. Second, you need to decide whether selling a rental property at a given time is right for you. Only after these critical pieces are in place can you move forward with a crafting a 1031 deal.
To begin, contact a lawyer or legal representative who is well-versed in 1031 laws. You must appoint a Qualified Intermediary for the duration of the process. Once you appoint the intermediary, you’ll have a list of predetermined steps. These include:
Whether you’re a seasoned veteran or completely new to the world of real estate investing, planning and preparation is critical. When it comes to guidance and insight on 1031 exchanges, you simply can’t afford to navigate the complexities by yourself.
Consult the professional team at Century 21 Northwest Realty for real estate investment and property management services today. Not only will you receive valuable education and insight on modern real estate trends, you’ll also receive practical advice for your unique situation. It’s never too late to get started on managing your investment options!
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