As an investment property owner or a business owner, you probably don’t like the idea of paying taxes, and many business owners pay them because they have to. But there is something known as a 1031 exchange that interests many savvy investors. A 1031 exchange allows you to postpone your tax liability on the sale of investment real estate and use the proceeds from the sale to invest in a replacement property of like kind.

The basics of 1031 exchange when selling an investment property

If you are a business owner in real estate, you have likely experienced your investment properties appreciate over time. When it’s time to relinquish the property, you must pay capital gain tax. The tax amount includes federal capital gain tax, state capital gain tax, depreciation recapture, and potential net investment income tax.

However, a 1031 exchange enables you to defer the tax obligation if you reinvest the proceeds from the sale in a similar property. Similar or like-kind property means any other real estate asset used for investment purposes; therefore, it doesn’t include personal property.

For instance, if you wish to sell a business where you own its real estate, you can execute a 1031 exchange on the company’s real estate and simultaneously sell the business to a buyer. Alternatively, you can sell the business’s real estate only without including the business and benefit from a tax deferment as you continue to operate the business. However, you should seek professional advice from a 1031 exchange expert such as Delaware trust 1031 exchange to better understand your potential tax liabilities.

Why a 1031 exchange?

In the period you have owned an investment property in real estate, you have depreciated more value of the property, reducing many of the tax benefits of owning real estate. So a 1031 exchange allows you to recoup the tax benefits when selling the property to reinvest.

Another major advantage of a 1031 exchange is that you get to purchase a replacement real estate with better return prospects while deferring any depreciation recapture. In simple words, you take advantage of the new property’s clean slate depreciation clock.

Some of the 1031 exchange rules

  • The 1031 exchange should involve like-kind property. That includes real estate you own as part of a business operation. But it excludes your primary residence, securities, or properties you intend to flip.
  • You may disqualify the entire transaction and lose all the tax benefits if you touch any of the cash from the sale. As such, you must hire a qualified intermediary to facilitate the transaction.
  • The full equity from the sold or relinquished property must be transferred to the replacement property.
  • The IRS allows only 45days from the sale of the old property to identify the replacement property.
  • You must complete the 1031 exchange within 180days after the sale of the old property.

A key takeaway

A 1031 exchange can be complicated, depending on your situation. The rules are also sensitive and specific so having a seasoned 1031 exchange intermediary is essential. You also need to plan and seek advice before executing the exchange.