When you sell a property, you have to pay tax on the transaction. But there is a way to defer the capital gains tax and reinvest the proceeds from the sale into another property that meets certain criteria. It’s called a 1031 exchange.
The 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell investment property and reinvest the proceeds from the sale within certain time limits in a like kind property or properties.
Are you considering conducting a 1031 exchange?
So, you’re thinking about getting rid of one property and replacing it with another. That’s great! A 1031 exchange is a simple way to avoid paying taxes on any gains. But remember, there are steps you need to take in order to avoid any tax headaches. We see people get this wrong all the time. And it can be a costly mistake. For example, if you have $250,000 in capital gains, that could cost you as much as $50,000. Just on the federal level. Or worse, you end up with an asset you didn’t want.
How To Qualify For A 1031 Exchange
To take full advantage of the tax benefits of a 1031 exchange, you must meet specific criteria. The following guidelines will help you understand how to qualify for a tax-deferred 1031 exchange.
- To receive the full benefit of a 1031 exchange, your replacement property should be of equal or greater value.
- Your net proceeds from the sale must be reinvested in another investment property.
- You must identify your new property within 45 days of selling the original.
- You must close on the new property within 180 days of selling your original.
- In order to avoid any tax headaches there are some steps you need to take.
A 1031 exchange is only for real estate (land or buildings) held for investment or business use, not personal use. So you can’t swap your rental property for your vacation home and get the tax break. And if you trade away property that’s used partly for personal purposes — such as a weekend cottage you rent out part of the year — then you’ll have to pay taxes on that portion of the property.
Here are some things you need to know:
- Not every property qualifies for a 1031 exchange.
- You can’t use your own funds during the exchange process.
- The replacement property must be “equal or up” in value.
- Your replacement property must be like-kind.
Common Pitfalls We See People Making
When you do an exchange correctly, it’s a great way to defer your capital gains tax liability. When you do an exchange incorrectly, your tax bill can be even bigger than if you had never done the exchange in the first place. Any one of these pitfalls below could cost you dearly. And the costs could be far worse than just the capital gains ramifications. In fact, they usually are.
Here are 9 common pitfalls we see people making on their 1031 exchange:
- Failure to hire a 1031 intermediary
- Taking a bad asset in order to avoid tax
- Failing to identify in writing a replacement property within 45 days
- Failing to buy the replacement property within 180 days
- Poor planning that causes the new property purchase to fall through
- Using the wrong kind of property (i.e. personal property instead of investment/business)
- Failure to assess market risks on new property
- Hiring an accountant that doesn’t know how to report it
- Failure to inform your accountant
Ready To Learn More About 1031 Exchanges? Call Wasatch CPA Services
If you are looking to do a 1031 exchange, it is important that you make sure that you are working with someone who has experience in this area. The last thing you want to have happen is to receive tax advice from someone who has no idea what they are doing, which could lead to costly penalties or even worse, jail time. When it comes to tax law there is no room for errors. Get the right information if you know that this is something that you want to pursue as an investment strategy. If you want more information about how a 1031 exchange works and how to make it successful, give Wasatch CPA Services in Pleasant Grove, Utah a call at (385) 247-0165. Let’s get on a call and discuss what pitfalls to avoid.