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You just sold a house for profit — congratulations!
But there is one fee that can eat into your profit — and affect what you want to do with that money.
One real estate tax strategy to do this is to use what’s called a 1031 exchange to defer capital gains taxes on the property you sell.
In this article, we’ll take a closer look at how a 1031 exchange works.
What is a 1031 Exchange?
The capital gains tax is paid when you sell a property for a price higher than what you initially paid for it.
his tax rate can be anywhere from 0% to 20%, depending on a variety of factors, including the amount of your sale and your filing status.
A 1031 exchange allows you to sell one property and reinvest the money into another property — capital gains tax is then deferred.
For investors, this basically means you’re “swapping” one investment property for another.
Advantages of a 1031 Exchange
A 1031 exchange can be a great real estate tax strategy, especially for real estate investors.
By deferring the capital gains tax, all of the proceeds from a sale can go toward another property — a tremendous advantage.
Another advantage: the taxes you defer through a 1031 exchange are erased upon your death.
If you’re an investor, you can use a 1031 exchange to buy properties throughout your entire lifetime, effectively growing your wealth tax-free.
Disadvantages of a 1031 Exchange
Despite these advantages, there are disadvantages to consider associated with a 1031 exchange.
For example, if you use multiple 1031 exchanges but fail to complete one, your proceeds will be returned, and you may be liable for some or even all of the deferred taxes.
This is why it’s critical to use an experienced CPA or real estate attorney when utilizing a 1031 exchange.
Types of 1031 Exchange
There are four different types of 1031 exchange.
They include the following:
In a delayed exchange, you would sell the original property. The money goes to a Qualified Intermediary (QI). The QI will hold this money in escrow until you acquire a new property.
A simultaneous exchange occurs when you buy and sell properties on the same day.
A reverse exchange occurs when an investor finds a new property before selling the old one.
Your QI (called an Exchange Accommodation Titleholder) will hold title to the new property until you find a buyer for the “old” property.
In this type of 1031 exchange, you would identify the new property and make improvements while the QI holds title.
1031 Exchange Calculator
How do you calculate 1031 exchange?
You can use this real estate strategy by following these steps to determine the original basis of the property you sell:
- Determine the original purchase price
- Add the cost of any improvements
- Subtract any depreciation
This number will now become your original basis.
Now, determine the profit you’re making from the sale:
- Determine your selling price
- Subtract any selling costs
- Deduct your original basis from your selling price
This number will indicate how much profit you make from the sale and you can use a 1031 exchange to defer the capital gains tax.
The Bottom Line: 1031 Exchange
A 1031 exchange can be a valuable real estate tax strategy — as long as you understand and follow the strict rules.
Using a 1031 exchange is one of many ways that real estate investors can build their wealth safely.