3 Facts That Can Help You Better Understand 1031 Tax Exchanges
Posted on: 30 August 2021
Investing in real estate can be a great way to grow your personal wealth. Real estate investors are allowed to take advantage of certain tax benefits that can help them reduce their tax burden and retain more profit over time.
One of these tax benefits is known as a rental property 1031 tax exchange.
Understanding the nuances of a 1031 tax exchange can be challenging. Here are three facts that you can use to help you gain a better understanding of the 1031 tax exchange process.
1. Only Like-Kind Properties Qualify
In order to take advantage of a 1031 tax exchange, you need to know which types of properties qualify for exemption under this tax rule. The IRS only allows like-kind properties to be exchanged under section 1031.
Like-kind properties are any piece of real estate that is the same nature or character as the property being replaced. Both properties must be for business use, but they do not have to be of the same quality.
For example, you could exchange a large apartment complex for a vacant lot on which you will build new housing. The IRS recognizes all real estate property to be like-kind, no matter what improvements have been made to the properties involved in a 1031 exchange.
2. There Are Different Types of 1031 Exchanges
One characteristic that makes a 1031 exchange so confusing is that there are multiple types of exchanges. The type of exchange you will engage in depends on the timeline in which you purchase the new property that will be replacing an existing property.
If you choose to sell your existing property before investing in a replacement, you have a limited amount of time once the sale is finalized to buy a new property and fill out the 1031 exchange forms.
If you purchase the new property before you sell the old one, different forms are required to complete your 1031 tax exchange.
3. 1031 Exchanges Only Defer Capital Gains Taxes
The primary reason real estate investors use 1031 tax exchanges is to avoid paying any capital gains taxes. It's important to realize that a 1031 exchange merely defers these taxes, it doesn't eliminate them completely.
If you want to permanently avoid paying capital gains taxes on your real estate investments, you will need to work closely with your attorney to account for these taxes during the estate planning process.
If you don't plan ahead, whoever inherits your properties will be required to pay all deferred capital gains taxes after your death.
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