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Real Estate Taxes and What to Know About a 1031 Exchange

With the new year comes the much dreaded tax season. I picture everyone collecting their W-2s and mortgage or student loan interest statements, and catching up on all their itemized deductions for 2023. It’s not the best way to spend a winter day or evening, I know. 

Nor is it a popular subject for blog posts…

But everyone loves ways to avoid having to pay taxes. And, while it may not be the most popular topic, I thought I’d start off 2024 by talking about a particular tax code that allows one to defer paying capital gains taxes on profits made on the sale of their property.

I’m referring to a 1031 Exchange, and it’s a particular tax code that allows real estate investors to defer their capital gains tax burden.

There are a lot of misconceptions and conflicting information out there about a 1031 Exchange. So I think taking a closer look at a 1031 Exchange and ways to avoid paying capital gains taxes will be helpful.

I want to note that this is only a single blog post and isn’t a complete summation of the 1031 tax code. I aim only to give a general overview with key points to give you a better understanding of what a 1031 Exchange is.

First off, a 1031 Exchange only applies to real estate investing and not personal homes. This specific tax code doesn’t apply to folks who might sell the home they’re living in and buy a new home for personal use.

You might be thinking this tax code doesn’t apply to everyday people, but real estate investing is not exclusive to the big whig businessman in a power suit. Real estate investing is a great option for many people looking to diversify their portfolios and bolster their retirement options.

Though I won’t go into it today, you should know that investing in real estate is very common and doesn’t require a banker costume and a corner office.

Either way, if you’re not a real estate investor but still a fan of not having to pay taxes, do not fear or fret! Most likely any equity you make on the sale of your home is still protected from most, if not all, capital gains taxes.

The IRS allows an exclusion on capital gains taxes for a personal residence up to $250,000 for individuals and $500,000 for married taxpayers filing jointly.

This shelters you from facing federal taxes but not necessarily state taxes.

Whether you’re investing in real estate or simply selling your home, I recommend looking into and knowing about the capital gains tax codes for the state where the transaction takes place. Often state tax codes are different or have different rules and requirements and you might be obligated to pay taxes still.

Going back to a 1031 Exchange, anyone investing in real estate should know the benefits and rules associated with it. In short, it’s a tax break. But it’s designed to allow you to change or move around your real estate assets without having to worry about any tax burden.

A 1031 Exchange comes with rules, however, and real estate investors need to know the best practices and, sometimes, the only acceptable ways to use it without penalty. For example, proceeds from the sale of the home must be held in escrow by a third party before being used to buy a new property.

That means an investor cannot pocket the cash, use it at his or her leisure, and before filing his taxes buy a new property to wash away the tax burden on the capital gains.

Also, the new property must be similar to the previous one. The “likeness” of two properties is at the discretion of the IRS. But the eyes of the IRS are surprisingly generous here. If you own a multi-family and sell it to buy a commercial property like a strip-mall, the 1031 Exchange will probably still apply to you.

A big difference, according to the IRS, would be selling property in the United States and buying real property outside the states.

Of course, a 1031 Exchange shouldn’t be seen as a loophole. It should only be used by investors who are exchanging properties with no other intentions than to change or upgrade their real estate assets. 

All real estate investors should stick to handling transactions with open and honest intentions. Attempting to skirt around paying taxes by changing ownerships or falsifying records, etc. are good ways to get yourself in trouble with the IRS and the law.

I’ve reiterated that a 1031 Exchange is only applicable to investment properties, but you might be wondering whether it could apply to a second home or vacation home. The simple answer is no. If the real estate property you own is only used for personal living, you still cannot use a 1031 Exchange even if it’s not your “primary” residence.

However, if you rent out that home to short or long-term renters and it generates an income for you, then the property would meet the requirement for a 1031 exchange.

I should add that there is a way to use a 1031 Exchange on your primary residence, though the process requires some moving parts – literally. If you move out of your primary residence and rent it out for at least two years, you can sell the residence and be eligible to use a 1031 exchange for the sale.

A 1031 Exchange is a tax code, and, like most tax codes, is complicated and requires much attention to detail to understand it fully. Seeking professional advice and consultation is a must.

The bottom line with a 1031 Exchange is that it’s a very handy tax code for real estate investors. With everything in real estate, one should always rely on the experience and expertise of those who deal in real estate and/or handle real estate transactions.

If you have any questions or concerns, or if you want to ask me more about real estate investment possibilities, reach out to me today!

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Melanie Graham

Melanie Graham