Part II: The Tax Benefits of Real Estate Investing
In the first part of our Tax Benefit Guide, tax deductions were highlighted. In this edition, the focus is going to be on 1031 Exchanges.
Why should an investor care about 1031 exchanges? Referring back to Part I, depreciation is an important tax savings tool real estate investors use on a yearly basis. However, when it comes time to dispose of depreciated real estate, the total depreciated amount is subtracted from the original purchase price. For example:
Original purchase: $100,000
10 year depreciation amount: $10,000
New Cost Basis: $90,000
Sale Price: $125,000
Net Gain: $35,000
*Numbers are simple for an illustration, please refer to Part I for depreciation calculations
1031 Exchanges offer real estate investors an opportunity to defer these gains. The 1031 Exchange gets its name from Section 1031 of the tax code shown here:
Nonrecognition of gain or loss from exchanges solely in kind
No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.
Tax jargon aside, the IRS allows investors to defer taxable gains on property sales if the proceeds are used to buy a “like kind” property.
What is “like kind”?
Like kind is defined according to its nature or characteristics, not its quality or grade. There is a broad range of exchangeable real property. You can exchange vacant land for a single family rental but you cannot exchange real estate for artwork. After the exchange is deemed to be “like kind”, the investor utilizing 1031 must also ensure that both the relinquished and the replacement properties are held for investment purposes or for productive use in a trade or business.
Next, the investor has a few different ways to take advantage of the 1031 exchange. It does not necessarily have to be a 1 for 1 property exchange.
In order to make the most of a 1031 exchange, real estate investors should identify a replacement property — or properties — that are of equal or greater value to the property being sold.
There are three ways to do this:
- Identify up to three properties regardless of their value, or
- Identify unlimited properties as long as the combined value doesn’t exceed 200% of the property being replaced, or
- Identify unlimited properties as long as the properties acquired are valued at 95% or more of the property being replaced
Advanced planning of a 1031 exchange is the key to success. An investor has 45 days to find a property after selling the original investment. Therefore, investors usually have their strategy lined up so they can execute within that time frame. Failure to execute will result in no tax deferral on the original investment.
A 1031 exchange will not apply to all investors and can get complex. We recommend consulting a qualified professional to plan a potential exchange. Awning is here to help identify properties once a plan is laid out and we have the tools and resources to ensure you find a property within the 45 day window.
Note: This article is published for informational and educational purposes only. Awning does not provide tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.