The Benefits of Executing a 1031 Exchange: Plans to Save Money
Using the rules for like-kind exchange can defer a lot of taxes and save you a lot of money right now. Let’s talk a little bit more about what all is involved. Like-kind relates to the section in the tax code called 1031. So we’ll often refer to it as a 1031 exchange. We used to be able to do like-kind exchanges on all kinds of things. So it didn’t require a lot of big preparations. Like you could trade in a truck for a new truck, or you could trade in a truck for a car.
The tax code has changed and the 1031 exchange is only available for real property. So real estate, whether that’s land, commercial buildings, apartment buildings, residential homes, that’s pretty flexible, but it all has a component of being real estate. A 1031 exchange lets you take a piece of property that you’ve purchased in the past, sell it and exchange to buy a new piece of property or multiple pieces and defer paying taxes on the game.
So let’s give you a quick example. Let’s say that you purchased a rental property for $100,000, 10 years ago, and now you would like to buy another rental property that’s larger. You could take the piece of property that you purchased for a hundred thousand and let’s say that it’s now worth 400,000. You could sell that piece of property for $400,000 and reinvest it in a new piece of property or a bigger piece of property even, and not pay taxes on that $300,000 worth of gain right now that doesn’t mean it’s tax-free it’s deferred. That means it goes into the future.
On your tax return, when we start talking about the depreciation, we would actually be carrying forward with that previous property’s depreciation, the basis of your new piece of property would not be the $400,000 that you paid for it. It would be $100,000, let’s say it’s another 10 years and you sell that $400,000 property today for 800,000.
Now when you sell it that second time, if you don’t do another 1031 exchange, you would take the 800,000 that you sold it for, subtract it from your $100,000 basis, the original property, and pay taxes on 700,000 later in the future. So that’s how the strategy works, let’s talk just a bit about the specifics though, because they hold a lot of things that you must do.
First off a 1031 exchange is not a do-it-yourself project. It cannot be done after the fact, you must prepare for this. You must use a 1031 exchange intermediary. That is a third party, so once you decide you’re going to sell a property or you have an order to sell it, you will have some timelines that you need to follow. The timelines as of now are that you have to identify potential replacement properties within 45 days of the day that you sell the other property.
This property will be sold by the exchange intermediary and they will hold the funds in escrow while this entire transaction is taking place. The purchaser of the new piece of property will actually be the 1031 exchange intermediary and everything will get transferred back to you at the end of the deal. But everything happens through them. It’s kind of like using an escrow account.
So within 45 days, you’ve identified potential replacement properties. You can identify up to three of them within 180 days of the sale of that first property. You have to purchase the replacement property, so you get a lot of timing deadlines there to make sure that you qualify for and keep in mind either the selling or the buying on either side of this deal could contain multiple properties.
If you have questions about how the 1031 exchange works, I can help you with some of the general questions. If you have detailed questions, you really need to be in touch with a 1031 exchange intermediary. There used to be a ton of these. I will tell you they’re not nearly as many since the real estate market came down several years ago but do a little Google search in your area, ask for some referrals and I’m sure you’ll find some. I’m Donna Bordeaux, helping you save tax dollars.
Donna Bordeaux, CPA with Calculated Moves
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