Most people are familiar with the concept that when you sell a long term investment, you have to pay heavy penalties on your capital gains in the form of taxes. For most people, the capital gains made on an investment is taxed at 15%. California even has an additional 9.3% capital gains tax! These taxes can quickly eat into a fairly large margin of your potential earnings from a property. However, due to an often overlooked section of United States Internal Revenue Code (26 U.S.C. § 1031) known as the 1031 exchange, you may be able to bypass these capital gains tax and benefit much more from your earnings on a property.
Let’s say you purchased an investment property at $500,000 then, a few years later, you decided to sell that same property for $1,000,000, netting you a handsome $500,000 in profit. With the current capital gains taxes applied, you’d have to payback nearly $121,500; not even including the additional cost recovery recapture tax. This is a substantial loss in your net profit.
But, did you know there is a way to defer these taxes and not even pay a single penny? Yes, there is. It’s called a “1031 Tax Deferred Exchange”, and it’s a strategy utilized by savvy investors.
A 1031 Tax Deferred Exchange (1031 Exchange) is when you sell you property and buy another “like kind” of property while following a strict set of specific rules. It’s important to note that this strategy is for tax deferring at a later date. If you ever choose to sell all of your assets and leave real estate investing, you’ll still be on the hook for all of the taxes. However, for most people, the goal is to keep deferring the taxes for many decades, until they pass away. Think of the phrase “kick the can down the road” but in this case, you gain the kicking power of a pro NFL punter.
Imagine that you purchased an investment property for $1,000,000. Then, 10 years later, you sell that property for $2,000,00. The first step you’ll want to take is to hire what is known as a “qualified intermediary.” A Qualified Intermediary, known as a “QI” is an expert in 1031 Exchanges and they can guide you through the complicated process while acting as a middleman during the exchange. A QI is not something that you should bargain shop for. A QI with the trusted experience you need will be able to complete all proper legal documentation, act swiftly within tight time frames, and know all rules/steps involved–that is exactly what we at Ross Multifamily specialize in. At Ross Multifamily, we’ve handled thousands of 1031 Exchanges across the nation and are fluent in all of the latest regulations. If you have any questions or thinking utilizing a 1031 Exchange, contact us.
Now that you have a better understanding of the basics, let’s dig a little deeper into the specific rules involved.
There are two specific time frames that you need to be aware of:
1: From the date that you sell your property, you have a 45 day window to identify a new property or properties.
2: You have 180 days to completely close on a new property or multiple properties.
These days are non-negotiable. This means that if you can’t identify a property in 45 days, or can’t close because of financing issues within 180 days, you become ineligible to utilize the 1031 Exchange.
First let’s go over the specific options regarding the 45 day property identification process.
Option 1 “The Three Property Rule”: The Three Property Rules means that you can select three similar properties at any price. Most investors use this rule because when they sell one property, they often want to purchase a larger property. However, sometimes, investors want to sell their property and purchase multiple smaller properties. This is where rule number two comes into play.
Option 2 “The 200% Rule”: This option allows you to select an unlimited amount of properties so long as their total value does not exceed 200% of what you just sold your property for. In the example that we covered above, we sold our property for 2,000,000, so utilising option two, we could select unlimited properties up to a total value of $4,000,00.
Option 3 “The 95% Closing Rule”: This option is the most complicated of the three. It’s very similar to Option 2 in that you can chose an unlimited amount of properties. However, this rule requires that you must close on at least 95% of the properties. This rule is usually only utilized by the most experienced investors who are usually purchasing property in cash, limiting any potential financing issues.
We can help you select the proper identification option that best matches your investing goals. Once selected, we can also help you through the fairly simple 180 day closing process.
Now that you understand the options, how does it all work? Well, simply put, it works much like a regular sale but with Ross Multifamily acting as the QI; the go through mediary. Once the seller has their money in escrow and all paperwork has been signed, two transactions will happen simultaneously. Instead of selling directly to seller, you will sell to Ross Multifamily QI; we’ll hold the title. Then we will sell your old property to the new buyer immediately. The funds from the buyer are then given to us, as we act as a trusted holder for your funds during the 1031 Exchange period. Throughout the process, you are unable to touch any of funds.
The bottom line regarding 1031 Exchanges is that when selling your investment property, you must acquire an equal or greater investment property(s). The loan amount is irrelevant as long as the two amounts are satisfied.
The 1031 Deferred Tax Exchange is one of the best solutions to potentially wealth damaging capital gains taxes. Our expert team at Ross Multifamily can help guide you through the process and make sure that your valuable profits remain just that, profit.
Frequently Asked Questions
1. Am I allowed to utilize the 1031 Exchange If I am selling my investment home and want to instead purchase a different kind of property such as retail shopping center or industrial warehouse?
Yes you can utilize the 1031 Exchange because the laws clearly state that to be eligible, you must purchase a “Like Kind” of property. “Like Kind”, in this case, means any real estate. You can sell your apartment complex and buy a shopping center, or a piece of land and visa versa.
2. Is it possible to buy a property first, and then sell my property with a 1031 Exchange?
Yes, this is known as a reverse 1031 Exchange. It’s much more complicated, more expensive and requires that you find a buyer who will close on your property within 180 days after buying your new property.