Taxes rarely make for exciting reading material, but if you own an investment property, there's at least one set of IRS regulations you absolutely will want to understand: 1031 exchange rules. Why? Because normally when you sell an investment property for more than what you paid for it, you'd have to pay a hefty capital gains tax.
But with a 1031 exchange, you get to defer paying those taxes if you reinvest the proceeds in a new property, making an "exchange" rather than a sale. It's just that this transaction is subject to some strict regulations, so you'll need to follow the 1031 exchange rules to the letter.
Here's what you need to know to pull it off.
Do you qualify for a 1031 exchange?
Here are the basic requirements for a 1031 exchange, according to Los Angeles accountant Harlan Levinson:
The homes must be investment properties. This transaction is not for regular homeowners who live in the home they're selling (or buying). Both homes in question must be investments, whether you plan to (or did) rent it out to tenants or flip it after renovations.
The home you buy must be worth more than the one you sell. People benefit from a 1031 exchange only when the property they buy is of equal or greater value than the one they're selling -- in other words, they're trading up. For instance, maybe you bought a quaint summer cottage rental, but you want to cash that in for a larger mansion on the beach, or a duplex where you can rake in rental money from two families rather than one. If you intend to pay less for a new property, you'll pay taxes on the difference.
1031 exchange rules to follow
If you decide to do a 1031 exchange, once the money from the sale of your first property comes through, it will be held in escrow -- an independent account monitored by a third party. You won't be able to access the money until you close on a new property.
After the sale, the clock starts ticking for you to find that new property: You have 45 days to identify a new property (or properties) you want to buy. Once you do, you'll have 180 days to complete the purchase.
Since closing on a property can take time and is often unpredictable, many investors choose more than one property to buy with the hopes that at least one of them will come through. And this is fine, provided you follow a few more rules:
- Three-property rule: You can identify up to three potential properties to buy as long as you close on at least one of them.
- 200% rule: You can identify any number of replacement properties you want to purchase so long as their eventual combined fair market value isn't more than 200% of your relinquished property. So let's say you sell a property for $500,000. The combined market value of your purchase should be no more than twice that, or $1 million.
- 95% rule: You can ignore the 200% rule and identify any number of potential replacement properties for any amount as long as you buy 95% of the aggregate value of those properties. So if you sold a property for $500,000, you could identify five properties worth a total of $2,500,000. But you'd then have to actually buy at least $2,375,000 (that's 95%) worth of those properties.
While these rules are complicated, they must be followed -- there are no exceptions or extensions. If you mess up, the IRS could decide you don't quality for a 1031 exchange and send you a huge tax bill. So make sure you know how it works. If you're in doubt, consult an accountant or real estate agent for more details. For more information on 1031 exchanges, go to IRS.gov.