If you’re a Boston rental property owner wondering how to avoid paying taxes after selling a property, you probably have a lot to gain from doing a 1031 exchange. This program allows you to defer those taxes if you reinvest the earnings from your sale into another purchase. It’s a great way to continue investing in a competitive, high-rent market.
With a 1031 exchange, you can keep more of the money you’ve earned and establish a more effective long-term investment strategy.
As Boston property managers, we get excited about the opportunities a 1031 exchange can provide for the investors we work with. House values are higher than ever, and selling an investment property in this market will almost always lead to a painful tax bill. When you decide to re-invest the earnings into another income property (or several), you have a great situation in which you can defer taxes and increase the value and strength of your rental property portfolio.
But, you have to do it right. There are some complicated conditions and timelines that need your attention. You’ll need to surround yourself with some real estate, accounting, property management, and tax experts to really maximize what you can earn and save through a 1031 exchange.
We thought it would be helpful to have as many questions answered in one place.
Here’s what you need to know.
What is a 1031 Exchange?
Anyone who invests in real estate understands at least at a high level what this type of tax vehicle is. If you’re new to the rental real estate market, however, or you’ve never worked with a program like this personally, you may have some questions about the particulars of how it works. It’s not complicated, but it is detailed. Managing all those details can sometimes be a bit overwhelming, which is why getting some experienced help is so valuable.
The 1031 exchange is a tax resource that’s named for Section 1031 of the IRS code. It allows for rental property owners to defer the taxes that may be due on the sale of a rental property by investing those profits into the purchase of another rental property.
Most investors expect capital gains taxes when they sell an investment at a profit. But, if you’re willing to use the proceeds from the sale of your rental property to buy another income-producing property, you won’t lose any of those proceeds to taxes. The 1031 exchange does not cancel what you owe to the IRS. It merely defers the required payment of what is owed.
Rules for 1031 Exchanges
You have to exchange like properties for like properties when you’re taking advantage of this resource. So, you cannot sell a rental property and avoid taxes by purchasing a vacation home for your family. It has to be income-producing property with a value that matches or exceeds the property you’ve sold.
There are also deadlines when you’re taking advantage of this tax break. If you’re going to do a 1031 exchange, you have to identify the property or properties you want to buy within 45 days of closing on the property you sold. You also have to close on the new deal within 180 days of selling the original property. The entire transaction must be completed within those 180 days, otherwise you’ll be liable for taxes.
Here are some specifics to keep in mind as you’re choosing a replacement property for the one you’re selling:
- The exchange has to be for a like-kind property, and that’s defined according to the nature of the property or its characteristics as an income-producing property, not its quality or grade. This means that there is a broad range of exchangeable real properties. You don’t have to buy a single-family home if you sold a single-family home. You don’t have to exchange an apartment building for an apartment building. A condo can be exchanged for a commercial building, for example, or industrial property can be exchanged for residential.
What you cannot do is exchange real estate for stocks or a pricy collection of wine or original Renaissance art. Those investment exchanges do not meet the definition of like-kind property. You cannot hold the property for personal use or for resale, either.
- Timelines are crucial. In a market as active as this one, you’ll need to prepare to move quickly to find a replacement property before you sell the property you have. To receive the full benefit of a 1031 exchange, your replacement property should be of equal or greater value. You must identify that replacement property within 45 days of selling the initial asset. Closing on the sale of the new property must occur within 180 days of the initial sale.
- There are three rules to define identification and timing, and your requirement is to meet at one of the following:
- Identify three properties as potential purchases regardless of their market value. This is known as the three-property rule.
- Use the 200 percent rule, which allows you to identify unlimited replacement properties as long as their cumulative value doesn’t exceed 200 percent of your sold property’s value.
- Identify as many properties as you want as potential purchases as long as those you acquire are valued at 95 percent of their total or more. This, predictably, is called the 95 percent rule.
Remember – you have 45 days to identify replacement properties and then 135 additional days to close. Time is of the essence because if you don’t manage to identify the replacement properties or close before the deadline, you’ll be responsible for paying the taxes you’re trying to defer.
What if you identify and even purchase a replacement property before you sell the existing property?
This is called a reverse exchange. In such a situation, the property must be transferred to an exchange accommodation titleholder (or a qualified intermediary). You will also be required to sign and file a qualified exchange accommodation agreement.
Find a Qualified Intermediary
When we said you have to surround yourselves with professionals, that wasn’t just advice. There’s at least one professional who is legally required to be part of your 1031 exchange.
Under section 1031 of IRS law, any proceeds received from the sale of property remain taxable. So, to effectively and lawfully avoid paying those taxes during this transfer, you need to hand the money you earn from the sale of your property over to a qualified intermediary. As the seller, you will not ever touch that money. This is an important aspect of keeping the 1031 exchange accessible and effective.
The qualified intermediary is a professional or a company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. You don’t want to work with a qualified intermediary you know; it has to be someone with whom you have no business or personal relationship. This ensures the integrity of the exchange and the process.
Qualified intermediaries are not difficult to find, and you can always get a referral from your agent or your Boston property manager.
Benefits of the 1031 Exchange
There are several benefits for rental owners who use the 1031 Exchange, and you should talk to your Boston property managers about the possibilities. This exchange allows you to dispose of a property without paying capital gains taxes. If you’ve wanted to sell a property but you weren’t thrilled about paying the taxes, this is one way to continue growing your investment portfolio.
Other benefits include:
- Increasing the number of assets in your portfolio or diversifying what you already own. When you sell one property and make a lot of money, you can use the proceeds to buy two or three properties instead of just one. This provides you with additional income streams.
- You can save on maintenance costs. If a particular rental property has stopped cash flowing because of all the maintenance and repairs that have been necessary, you’ll be able to take it out of your portfolio and replace it with a newer property that has fewer expenses attached to it.
- You can stay invested in the real estate market. Many investors hesitate to sell a property because they know it can be expensive to re-enter a growing market. With a 1031 exchange, you can sell that property and continue investing in real estate that will appreciate in value.
- You can capture depreciation. When you sell your rental property, those capital gains taxes are calculated based on the net-adjusted basis of your property, and that amount will reflect the property’s original purchase price, plus capital improvements minus depreciation.
We have a lot of experience helping owners and investors succeed with rental properties and investment portfolios. If you have any questions about the 1031 exchange or anything pertaining to property management in Boston, please contact us at Platinum Realty Group. We’d be happy to evaluate your investment portfolio and talk about ways to increase the value of what you own. One of the best options might be a 1031 exchange.