Real estate is the best asset class for building and preserving wealth. There are countless tax-saving incentives when it comes to real estate, helping you keep more of your hard-earned money to grow your portfolio.
The problem comes when you sell a property, as you'll be liable to pay capital gains tax on the profit, regardless of how long you've held onto it. Luckily, there's another benefit that helps you to defer capital gains tax when selling an investment property; 1031 exchanges.
If you're selling one property in order to purchase another (or multiple new properties), then you can defer your taxes, allowing you to put more money into your next investment.
But what exactly is a 1031 exchange and how do they work to preserve your wealth? Keep reading below to find out now.
What Is a 1031 Exchange?
The 1031 exchange comes from section 1031 of the IRS tax code. It states that investors can sell an investment property, and rather than pay the required capital gains tax, they can defer it, so long as they put the proceeds of the sale into another investment property.
The properties must be like for like, i.e. one investment property for another. They cannot be used in a primary residence or vacation home.
By using a 1031 exchange, you are essentially swapping one property for another. And you can perform as many 1031 exchanges as you want.
Many investors continue using them as a way to build their portfolio, deferring all of their capital gains tax along the way.
Benefits of 1031 Exchanges
The 1031 exchange allows you to build your wealth on a tax-deferred basis. The problem is that eventually, when you sell and don't use the proceeds to buy a new property, you'll be liable for one final tax bill at the long-term tax rate of either 0%, 15%, or 20% depending on your income bracket at the time.
However, if you hold until your death, your tax liability will die with you. So your heirs can receive the properties without a tax burden, making this an excellent tool for estate planning.
1031 Exchange Rules
There are a few very specific rules for 1031 exchange opportunities that you need to understand before performing you start. The most important is the timeframe associated with it. You have to meet both the 45-day rule and the 180-day rule.
As soon as your original property sells, your 45-day countdown begins. You have 45 days to identify, in writing, the property that you intend to finance with the proceeds of the sale. And you can actually identify three properties, just in case the first one or two fall through.
The 180-day rule also starts once your original property sells. You have 180 days to close on the new property.
Lastly, you need to use a qualified intermediary to handle the swap. When your property sells, all of the proceeds must go directly to the intermediary. If you touch the funds, the 1031 exchange isn't valid.
When you buy the new property, the intermediary releases the funds directly to the title company, not to you.
1031 Exchange Real Estate Investment
1031 exchange real estate investments are one of the best tools for savvy investors. They give you the ability to grow your portfolio much faster and to plan your estate with confidence.
1031 exchanges aren't the only thing that will make your investments easier. If you want to save time, so you can focus on finding new deals, then you should hire a property management company to make your rentals as passive as possible.
Get started with property management in the Baltimore area here.