1031 Exchange: A Real Estate Investor’s Best Friend
It is very likely that you have heard before that real estate creates millionaires. Well-known billionaire, Andrew Carnegie, known for the expansion of the American steel industry, famously said that 90% of millionaires became wealthy through real estate. But is it really that easy?
Did you know that you can pay little to no tax on capital gains at the time of buying and selling real estate? Well, that is, if you meet the requirements of a 1031 exchange. I can bet you were never taught this in school! Let’s dive into it.
What is a 1031 Exchange?
A 1031 exchange (named after Section 1031 of the Internal Revenue Code) in basic terms is the swap of one investment property for another. It sounds easier than it really is, so let’s put it in technical terms. A 1031 exchange allows an investor to limit or avoid paying capital gains taxes when selling an investment property and buying a new one with equal or greater value at the time of the exchange.
The most common 1031 tax form used is the Like-Kind Exchange. This means the new property must be somewhat like the property being replaced. The new property must be alike in the same nature, character or class as stated by the IRS. When an exchange is complete, the parties will file Form 8824 to the IRS along with their federal income tax return.
This doesn’t mean that you can qualify for a 1031 exchange and delay paying your capital gains taxes as long as you want. There are restrictions.
Restrictions
So now you have all of these untaxable capital gains and you can go buy yourself a new sports car with that money, right? No. Taking control of any and all of the cash before the exchange is complete will absolutely disqualify you from the exchange itself. All capital gains from the property will immediately be taxable.
This is where a qualified intermediary comes in. A qualified intermediary is a person or company that agrees to facilitate the exchange and holds all of the funds involved until the exchange is fulfilled. This person or company cannot have any relationship to the parties involved.
This step in the process is only necessary though if going through a delayed 1031 exchange. However, this is the majority of exchanges. Unless you are able to find someone with the property you want and they want the property you have, which is very uncommon, it will most likely be a “delayed” exchange. There are two important timing rules to understand when going through a delayed exchange:
45-Day Rule
The IRS states that within 45 days of the sale of your property, you must designate your replacement property. This has to be put into writing and signed off by you, then given to the intermediary. You can designate three properties as long as you choose to close on one of them as the final property.
180-Day Rule
This is all about the end goal. Within 180 days of selling your property, you must close on the new one. The property you close on must have been one of the properties designated in that first 45 days of selling your property.
The Good, The Bad, and The Ugly
So maybe you’re ready to get rid of a property and invest in a new one. Great, now you understand what a 1031 Exchange is. Remember that this can be an amazing tool when looking to upgrade properties and increase your equity.
It is important to understand everything about this exchange. Know what you are getting into before you do. For example, you have to consider mortgage loans or debt on the new and old property, so you are not stuck with money you owe as your liabilities increase.
Also make sure that you are not doing this exchange alone, and that you have experienced parties involved (example: Real Estate Broker, Qualified Intermediary, Real Estate Attorney, Accountant). Calculate your financials beforehand and meet with an accountant to fully understand where your money will be coming in and going out.
Although it seems like a lot of steps, any real estate investor will tell you the reason they invest in real estate is the tax advantages that are available. So, don’t be scared off by the research and paperwork involved, and embrace the transition into that next phase of increasing your equity and net worth.
Whether you need more information regarding a 1031 exchange or you are a seasoned investor looking to complete a 1031 exchange, Contact Tannehill Law if you are seeking professional legal guidance to assistance you in your next transaction
Author: Sean Tannehill; Co-Author: Melissa Tannehill
Three Important Tax Benefits of Owning Real Estate
Tax season can be a stressful time for everyone. No matter how much you prepare, it’s not unusual to get to February and learn that you owe the Government more than you originally thought. This year is particularly complicated in light of COVID-19 and the extension of the new tax deadline to July 15, 2020.
While there is no way to avoid the stresses of tax season this year, there are ways that you can make it go a little smoother next year. One of the most impactful things that you can do in the year ahead is purchasing a home.
There is a handful of tax benefits that Illinois homeowners see around tax season including deductions, credits, and tax-free profits.
Deductions
When you are looking to legally lower your tax liability, a deduction is one of the easiest ways to do so. When looking to deduct, you should consider what expenses you have incurred over the year, and subtract it from your gross income. When you own a home, there are a variety of ways to achieve this.
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Mortgage Interest Deduction
This allows you to deduct interest paid on your mortgage. There are different regulations and limits set on this depending on marital status and how you file. Taxpayers can deduct mortgage interest paid on up to $750,000 in principal. Investment property mortgages are not eligible for the mortgage interest deductions, although mortgage interest can be used to reduce taxable rental income.
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Mortgage Point Deduction
Many homeowners also have eligibility to deduct paid mortgage points from their taxes. Mortgage points are fees you pay in order to decrease the interest rate. Each of these points costs 1% of the overall loan amount. If you choose to pursue this route, you can deduct the points over the life of the loan or in the year they were paid.
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State and Local Taxes Deductions
When purchasing a home, it is important to consider the deductions for state and local taxes. This includes any property taxes that you pay on your home. There is a $10,000 limit per/household for these deductions.
Many Illinois residents find this deduction cap to be a disadvantage because of the state’s higher property tax bills.
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Home Office Deductions
If Americans have learned anything from the latest COVID-19 pandemic, it is that many jobs can function remotely from the home. If you are considering adding a home office to a new home, then this is another valuable item that you can to write off.
In order to qualify for this deduction, the space that you assign as the office must be used regularly for business. The space must also be exclusively for business. This means that you cannot just add a desk to a bedroom and write off the entire space.
Credits
In addition to the tax deductions that you can receive when you own your own home, you can also be entitled to credits that reward you for making your home more energy-efficient. The residential energy-efficient property credit will offer 22% to 30% of the cost back to you if you make improvements in the home that follow a more Green living standard. It is an incentive set in place to help encourage homeowners to make eco-friendly changes to the home. Some of these changes might include but are not limited to, adding solar panels, a solar water heater, wind turbines, or geothermal heat pumps.
Tax-Free Profit
If you are looking to sell your home, you can still receive tax benefits in the coming year. Unlike most profits, the capital gains accumulated when selling a house can be tax-free up to $250,000 (if you are single) or $500,000 (if you are married filing jointly). In order to qualify for this benefit. The house must have been your primary residence for at least two out of five years before the final sales date.
Remember to bring your Settlement Statement to your accountant if you purchased or sold a real estate during the tax year. If you are looking to purchase or sell a home or investment property and would like to know more about tax benefits and consequences, contact your accountant and Tannehill Law today.