Let’s talk about one of the most powerful wealth-building tools the rich use to get ahead in terms we all can understand. Anytime you sell an asset for more than you originally paid, you are subject to taxes on the capital gains. The difference between the price you sold the property for and the price you originally paid to acquire said property (minus the cost of any improvements) is the capital gain. Simply put: Capital gains = Profit.
Brief interruption – It’s important to note we’re talking about investment properties here! For many of us, when selling a primary residence, capital gains are tax-free. This is due to the fact that you can exclude up to $250,000 of the gain from your income if filing single and up to $500,000 if married filing jointly. Now back to regularly scheduled programming!
The tax rate you actually pay on your capital gains depends on various factors like income, tax filing status, and length of ownership. No one wants to take a big tax hit and savvy investors have figured out how to avoid doing so. During my time managing and selling Orlando short-term rental properties (which was the first time I was introduced to this concept), the 1031 Exchange was used often.
How Does the 1031 Exchange Work?
The tax code allows you to move your money from one investment property to another without paying capital gains taxes on the profits from the sale. Essentially, you’re reinvesting the profit (your capital gains) from the sale into a similar investment enabling you to grow your portfolio while avoiding capital gains taxes.
What’s the catch? The 1031 Exchange process begins before the completion of the sale of the first property, so you must (1) know you’re taking this route ahead of time and (2) employ a qualified intermediary to handle the transaction. Your usual real estate brokerage will do. They hold on to your profit until it’s used in the purchase of another property. Next, your profit has to be re-invested within 180 days.
There are 3 rules that can be used in identifying properties for the exchange but, for simplicity, we will discuss the 3-property rule. Using the 3-property rule, which is the most common, the owner identifies 3 potential properties to replace the property being sold. Not just any properties for the sake of paperwork, but 3 properties he/she actually wants because 1 will have to close within 180 days.
And that’s it! Instead of paying capital gains taxes immediately, you defer them with the purchase of another investment property. There’s no limit to how many times you can use a 1031 Exchange to acquire additional property and defer the capital gains taxes. Quite the wealth building tool!
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