3 Important Points to Consider With Your First 1031 Exchange
There are many reasons to sell investment real estate, from wanting to diversify your portfolio to getting out of the landlord business and more. A 1031 exchange lets you defer or reduce taxes on that sale, possibly even eliminating taxes, while maintaining or growing your investment. Since you do not realize a capital gain, there are no taxes levied on the sale because the government views the exchange as an alteration in the type of investment. If you are considering a 1031 exchange for the first time, here are some things you should know.
- The Exchange Agreement Comes First
You must have a signed agreement with a qualified intermediary before selling your property. This is a key condition of using a 1031 exchange. If you sell before engaging an intermediary, you must pay taxes on the sale. When you use an intermediary, whether it is an individual or a company, you are actually selling them the property. They hold the proceeds until you can reinvest in like-kind property, in keeping with your agreement, or contract. If you do not sign an exchange contract with the intermediary before selling property, it is not an exchange, but a sale.
- Reinvest the Same Amount or More
When you reinvest sale proceeds, the value of the exchanged property must be the same or more than that of the original property. If it is not, you may have to pay taxes on the difference or amount of gain. This includes the equity from the sale. For example, if you sell a building for $10 million and pay off the same building’s loan amount of $5 million, you must reinvest the $5 in net gain, as well as the original $5 million in exchange property.
- Allowable Expenses
Several related expenses can be applied toward the net gain to offset the amount that you need to reinvest. Exchange and escrow fees, transfer taxes and commissions paid to a broker can all be paid out of the proceeds and not count as taxable gain. However, any credits the buyer of your property receives toward the purchase price are not the same as allowable expenses associated with its sale. You could be taxed for the credit amount.
Because it’s your money that an intermediary will hold, it’s wise to do a little research on the exchange company to ensure it’s a reputable one. You should also understand how the money will be used or held, to ensure it’s there when you need it.