Selling an investment property can be bittersweet. If you bought it, managed it, and sold it correctly, you should have a sizeable gain come time of sale. The downside is that you will likely have to pay taxes on the capital gain in the year you sell. Have you asked yourself, “how can I avoid paying taxes on the sale of my investment property”?
Luckly, there is a way, for the time being. A tax strategy that many seasoned investors use to level up their portfolio is a 1031 or “like kind” exchange.
What is a 1031 Exchange?
The name comes from the section of IRS tax code and the requirements of the exchange. What is a 1031 exchange? A 1031 allows you roll the capital gains from the sale of one asset to another asset of equal or greater value, of like kind. For example, you could sell a single family rental house and roll the gains into another single family rental or even an apartment building. What you cannot do is sell a rental property and buy a boat or crypto or stake in a Himalayan yak farming operation.
IRC Section 1031 provides an exception
and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property
as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC
Section 1031 is tax-deferred, but it is not tax-free
The purchase price of the target asset also has to be larger than the property being sold. There are also some timing requirements in which both transactions need to take place. The new property(ies) need to be identified in 45days and closed on in 180 days.
You, as the seller, cannot personally receive funds from the sale. The transaction needs to be handled by a qualified intermediary. The intermediary manages the flow of capital from the sale into the property being acquired. At closing, after any debt is paid off, the remaining funds are wired to an escrow account that the intermediary has access to. You are also given access to the account but cannot withdraw any of the funds. The intermediary will then wire the funds when it comes time to close on the target property. Please reach out if you would like the name of a qualified intermediary in your area.
Your CPA will need to handle filing the appropriate forms come tax time but until you sell the target property, your capital gains remain invested in the new property, tax free. In fact, you can continue to do 1031 exchanges until you’re ready to realize the gain or you die. To be clear, you will not avoid paying taxes forever but will defer them until you’re ready to realize the gains, down the road.
See how I used this strategy and others to Achieve Financial freedom
I can’t underscore enough how powerful of a strategy this is. It’s like the oh so familiar strategy of trading small houses in Monopoly for larger hotels. Starting out, most investors begin with smaller, cheaper properties. Once you accumulate some equity through forced or natural appreciation, that equity can be traded in for larger properties that provide a better return and better economies of scale. Utilizing a strategy like this will allow you to realize your investing goals at a much faster rate by keeping all of the equity accumulated across your properties. If you’re interested in using a like kind exchange, please sure to consult with your CPA and attorney. Both of which I am not. There are some hoops to jump through to pull off a successful exchange but the benefits far outweigh the challenges.
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