Taxes are one of those things that the majority of people, including investors, just accept and pay. However, there are many deductions and tax credits that can help investors keep more of their hard earned profit in their pockets. If you are investing or thinking of investing in real estate, the 1031 Exchange Rule is something you need to know about.
When a piece of property is sold for a profit, the seller is typically required to pay capital gains tax on the amount that you sold the property for that was over the price you purchase it for. However, by using the 1031 Exchange Rules you can avoid capital gains tax if you are investing that money directly into purchasing another investment property.
There are several requirements to using this tax advantage and you will want to make sure you carefully adhere to each one:
This only works if both the property you have sold and the property you are purchasing are investment properties. You cannot take advantage of avoiding capital gains if either one of the houses is your residential property. However, it doesn’t matter if you flipped it or rented it, as long as it was an investment property.
You can only use the 1031 Exchange if the new property that you are purchasing is worth as much or more than the property that you sold. If you are going to be paying less for the new property, you will be required to pay the tax on your profit. However, if you are purchasing a house that is equal to or more than the previous property, you still qualify.
If you are planning on taking advantage of the 1031 Exchange Rules there are some important things you to need to know and follow. When your property sells the proceeds from the sale will need to be held in a third party escrow account until they are transferred over through purchasing the next property. You also need to be prepared to act fast because you will only have 45 days to purchase your next investment. This can be a tough guideline to follow, so there are a few considerations to help you out.
Three-Property Rule – You can have three properties that you are looking at investing in, as long as you purchase one. Having multiple properties in the works can keep the process moving along if one of the properties ends up falling through.
200% Rule – This one gets a little trickier. You can identify an unlimited amount of potential properties to purchase as long as their fair market value does not exceed 200% of the property that you sold. For example, if you sold a house for $250,000 then the properties that you are looking at cannot exceed $500,000.
95% Rule – What if you want to consider investing in more properties than the 200% rule allows? That is not a problem as long as you follow the 95% rule. You can identify any number of potential properties to purchase, no matter the fair market value, as long as you end up purchasing 95% of them.
While these rules may seem very stringent and might not make sense to you, it is important as an investor that they be followed if you are using the 1031 Exchange Rules. If you avoid paying capital gains by going this route and then don’t stick to all of the rules and guidelines, you risk receiving a tax bill from the IRS. If you have any questions on how to take advantage of it, speak with a certified tax professional.