The 1031 exchange is a way for owners and investors to defer capital gains tax when selling an asset. This is one of the more complicated transactions to successfully complete, especially now that the tax code has changed. Learn more about how 1031 exchanges work, how they can save Animas Valley homeowners in the short-term, and what can be done to maximize the efficiency of the exchange.
The Basics of a 1031 Exchange
A 1031 exchange occurs when an owner sells an appreciated property and simultaneously purchases property of the same value. When the owner completes a 1031 exchange, they are exempt from paying capital gains tax.
There are a few basic rules that homeowners need to know for a 1031:
- The home cannot be a primary residence.
- Homeowners have to name a replacement property within 45 days.
- There are ways for homes to still be taxed (see below).
When to Choose a 1031 Exchange
Most people will choose a 1031 exchange when their second home or vacation home has increased strongly in value. Capital gains are added to a person's income for that year, and if they're high enough, the gains can quickly push an owner into the next tax bracket. When capital gains tax can take up 20% of the total gains, this is a substantial enough charge that owners may want to avoid.
For example, a homeowner purchases a vacation home for $100,000 and it sells for $430,000 five years later. After all taxes and fees are deducted, it results in capital gains of $300,000. If the owner pays full tax for the home, they would be giving $60,000 to the government.
1031 exchanges are often popular among serial investors because of their relative flexibility. Not only are there no limits to how many times a person can complete a 1031, but property owners are welcome to purchase any type of property they choose. (So if they sell a single-family home, they do not need to purchase another single-family home to qualify.)
What to Know
Homeowners will still need to pay their capital gains tax eventually if they ever choose to sell their appreciated property without buying another property of the same value. In addition, some people may still have to pay taxes even if they do choose a 1031 exchange, in the form of a depreciation recapture gain. This occurs when the IRS taxes total depreciation claimed as additional income. This clause is rarely invoked by the IRS for a property sale and only applies if the sale price exceeds the adjusted cost basis.
The exchange laws do not require the owner to find a suitable replacement property immediately after they've sold their second home. However, they are required to update their home search progress within 45 days after the close of the sale. If the property owner can't decide, they can name up to three potential properties that they are actively considering.
During this time period, a Qualified Intermediary hold the profits of the original sale in escrow until the buyer successfully closes on the new property. (The Qualified Intermediary is typically either a CPA or a lawyer.) If a seller chooses several properties, they must buy at least one of them within 180 days from the sale of the last purchase.
Understanding Misaligned Values
It can be difficult to match the price of the home sold with the price of the home purchased. If this happens, it will result in misaligned values. If there is any extra money left over from the sale, the intermediary is required to release the funds back to the seller. However, these funds will likely be reported as an official capital gain.
If the new property represents a decreased liability for the owner, this will also be treated as a financial gain and additional income. In other words, it's possible for the owner to be taxed on their exchange even if the two properties are perfectly aligned.
Absorbing the Risks
Most people won't attempt a 1031 exchange alone if they've never tried it before. The tax code laws are somewhat loose, and some officials may interpret them differently than others. This has led to some reports of 1031 transactions being delayed or canceled altogether. In addition, the rules of depreciation and deductions can quickly complicate the numbers. Homeowners are allowed to deduct all costs related to the home sale from capital gains, including the real estate commission, staging costs, and even the closing costs from the original sale. Having a financial advisor or a real estate lawyer can be especially helpful when lining up the two values of the property.
A 1031 exchange isn't the only way to avoid or minimize capital gains taxes. Talking to somebody who understands the process can make it easier to see if this financial maneuver will help or hurt the owner overall.