The 1031 Exchange: A Magical Real Estate Tip You Need to Know!
This real estate trick is no illusion—it’s a legitimate way to level up your property game. In this guide, we’ll explore the concept of the 1031 exchange and help you determine if it’s a good fit for you.
What is a 1031 Exchange?
Picture this: You own a stunning lake house, but you’ve got your eye on a more lucrative duplex in a ski resort. Enter the 1031 exchange, the ultimate property trading card. A 1031 exchange allows you to swap one investment property for another without immediately paying capital gains tax on the transaction.
It’s like trading your Pomeranian for a unicorn. By deferring the capital gains tax, you can reinvest that money into a new property, increasing its earning potential.
Benefits of a 1031 Exchange
- Big Tax Savings
Imagine you own a rental property that has appreciated significantly in value over the years. If you were to sell it outright, you’d be hit with a big, bad capital gains tax. In Wisconsin, capital gains tax can be up to 20%—ouch! But with a 1031 exchange, you can sell that property and immediately reinvest the proceeds into a new income property, all while deferring* the tax bill.
*It’s important to note that the 1031 exchange doesn’t exempt you from taxes completely. Instead, it allows you to defer the payment. This allows you time to earn money from your investment before making the payment.
- Grow Your Real Estate Portfolio
Besides saving you from the clutches of capital gains tax, a 1031 exchange allows you to grow your real estate portfolio and increase your cash flow. It’s like unlocking your property’s hidden potential and adding an extra zero (or two) to your bank account.
Is a 1031 Exchange Right for You?
Recipients of a 1031 exchange need to meet certain requirements:
- It must be an investment property
The property sold and the property acquired must both be held for investment or business purposes. Sorry, your personal residence doesn’t qualify.
- You must be making a similar trade
The 1031 perk only works with “like-kind” properties, so there’s no trading in your rental home for a herd of dairy cows.
Let’s say you’re a real estate investor longing for a change of scenery—maybe swap a residential rental for a commercial space in a bustling city. Or perhaps you’re a savvy entrepreneur looking to consolidate multiple properties into one high-performing asset. Whatever your real estate dreams may be, a 1031 exchange could be the ticket to making them a profitable reality.
The Steps to Securing a 1031 Exchange
Step 1: Pick out your properties
First, identify the property you’d like to sell and the one you’d like to buy. The properties must be of “like-kind”. This essentially means that they have to be of the same nature (i.e. two vacation homes). But they don’t necessarily need to be the same quality, allowing you to level-up your investment gains.
Step 2: Choose an intermediary
To make sure you don’t accidentally swim in a pool of cash before the exchange is complete, consider working with a qualified intermediary (or exchange facilitator if you want to get fancy). These professionals hold your funds in escrow until the exchange is all wrapped up.
Step 3: Determine how to allocate your profit
Not all the revenue from the sale of your old investment property has to be re-invested into the new property. But as a general rule of thumb, you can defer capital gains tax only on the portion that you reinvest. If you keep some of your proceeds, you may end up paying tax on that portion now.
Step 4: Don’t miss any deadlines
You have 45 days from the date your property sells to identify replacement properties. You must buy the new property no later than 180 days after you sell your old property.
Step 5: Tell the IRS about your Transaction
You’ll need to file IRS Form 8824 with your tax return. On this form, you’ll describe the properties, give a timeline, and explain who was involved in the transaction.
Taxes can be a huge headache. If you’re interested in this type of transaction, let us know! We can help walk you through the complexities of the process and point you in the direction of trusted mortgage brokers and tax professionals to add to your team.