Sales in the once-scorching U.S. housing market may be cooling, but property values are still way up: Between October 2021 and October 2022 alone, prices of existing homes grew 6.6%.1 For investment-property owners looking to sell, historically high prices could mean commensurately high capital gains taxes.
Such sellers might consider a so-called 1031 exchange, which would allow them to defer taxes by using the proceeds of the sale of one investment property to purchase a similar property.
"A 1031 exchange is sort of like having a tax-deferred investment account, but for real estate," says Hayden Adams, CPA, CFP®, director of tax and wealth management at the Schwab Center for Financial Research. "There's no limit to how many exchanges you can do, so you can roll over any gains again and again—and you'll owe taxes only once you decide to keep, rather than reinvest, the funds."
However, 1031 exchanges live by very specific rules. Here are a few to keep in mind:
- The buildings, land, or other real estate must be "like-kind" in nature—meaning the properties being sold and purchased must both be an investment or part of a business; a personal residence doesn't qualify.
- To receive a 100% tax deferral, the property or properties acquired must be equal to or greater in value than the property being sold.
- From the date of the sale, sellers have 45 days to identify the new property or properties and 180 days in total to complete the purchase.
- Proceeds from the sale must be held by a qualified intermediary—an independent person or entity with no financial or personal connection to the seller. The seller cannot, even temporarily, take possession of the funds.
"People run afoul of 1031 requirements all the time," Hayden says. "Even one tiny error will nullify the exchange, and you may be left owing taxes, late penalties, interest, and possibly even a 20% negligence penalty."
To avoid a mishap with a 1031 exchange, Hayden recommends that investors:
- Document everything: To claim something as a rental property, you need proof that you rented it, including contracts and payments.
- Open a dedicated bank account: A separate account makes it easier to prove rental income and property-related expenses.
- Create a separate entity: To keep personal and investment properties separate, consider establishing a business entity, like an LLC, for your rental. This has the added benefit of offering potential legal liability protections.
- Consult an expert: It's wise to find a CPA or an attorney who specializes in 1031 exchanges. "There are specific experts who know all the legal ins and outs, as well as what paperwork to file and when," Hayden says. "Some may even be able to help you find your next property."
1National Association of Realtors®, Summary of October 2022 Existing Home Sales Statistics, 11/18/2022.
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