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What Is 1031 Exchange?

Do you know that you have to pay tax if your profit on selling your own home exceeds certain limits?  According to IRS, you don’t have to pay tax if your gain from selling your OWN home is less than $250K – if you are a single filer – and less than $500K if you file jointly with your spouse.

A couple things you need to be aware of.  To qualify for the exclusion (not to pay taxes), you must own your home and occupy it as your primary residence at least two (2) of the last five (5) years before you sell it.  In fact, it does not need be a house, it can be an apartment (4 units or less), condo, townhouse, or a mobile home (manufacturing home).

What’s two of the last five years?  The IRS has been easy on you on this aspect.  That means you don’t have to live in the house (condo, apartment, etc) at the time you sell it.  You could have rented it out for one year, live in it for two years, and rent it out again for two years and then sell it.  Altogether, it is five years.  Of course, you have to keep track of the time periods to avoid future issues with IRS.

Then comes the 1031 exchange.

We only suggest this option (1031 exchange) for consideration when you (the seller) think the capital gains from your house are more than $250K (if you are a single filer) AND you are seriously thinking about leveraging the house for future investment[1].

If your capital gains are more than $250K you have to pay taxes to IRS.  But IRS allows you to convert your home into a rental property and then rent it out for 18 months before selling it.  BUT you have to live in it for two out of the past five years.

And once you accomplish the required time periods, you could exclude capital gains taxes up to the threshold amount of $250K and defer paying taxes on any gain above the $250K amount.

There is a reason that 1031 is usually called tax-deferred exchange.  You can only defer taxes until some time into the future – you will be asked to pay taxes when you stop using 1031.

But 1031 is a very important tool that allows you, as an astute investor, to leverage your current simple real estate holdings into significant wealth in the future.

Using the scenario above, you then can exchange your house (now an investment) to a larger property.  No, it does not have to be another house.  It can be almost anything of the same of larger value[2].

A COUPLE RULES IN 1031 EXCHANGE

An intermediary to handle the funds:  Yes, once you decide to use 1031 and need to exchange (sell) your current property into something larger (in value), you will need a “middle man” – an intermediary – to property handle the funds and process.

An intermediary will receive the cash from your sale (you are not allowed to touch the proceeds) and will apply it towards your new purchase (you are purchasing something larger).

Your 45 days and six months timing rules:  there are some catches in 1031 that usually “scare off” new investors (those who first learn about 1031).  You have only 45 days to identify the replacement property (the one you are buying) after you closed on your property.  That means you have to let the intermediary know within 45 days (calendar days, not business days) the property you are buying.

When IRS says 45 days, it’s really 45 days.  There are no excuses.

And then you will have 135 days to close on the new property (if it took you exactly 45 days to identify it).  Another way to interpret this requirement is you have to close on the replacement property within 6 months (180 days) after you close on your property.

It’s pretty simple huh?  It’s one of the best, if not the best and only best, vehicle for anyone who wants to become a serious real estate investor.  We cannot think of a better tool to leverage and accumulate your wealth than 1031 exchange.  We hope you could give it some thoughts in your investment journey.

 

[1] Since each individual’s tax situation is different, we strongly encourage you to talk to a CPA or tax attorney about your situation before taking actions.

[2] Again, please consult with your CPA about what can be used in the exchange to avoid triggering tax penalty.

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