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Selling your rental property minus the tax burdens

The word TAX cut out of metal

While it is true that investing in real estate is a highly lucrative affair, the costs of doing so can be quite staggering. Whether you’re buying or selling a property or holding on to primary residence or a commercial building, you’ll be handing over a huge chunk of your finances to the taxman.

Taxes for commercial properties like rentals for business or for residing in take the form of the capital gains tax. This is computed based on the profit you earned from the sale.  If you do a Section 1031 exchange, however, you can avoid paying any capital gains tax at all.

What, exactly, is a Section 1031 exchange and how does it help in deferring the huge capital gains tax? Also known as a Like-kind Exchange, this particular transaction involves reinvesting proceeds from the sale of your property directly into another investment property without keeping any cash from the sale for yourself. It’s considered an excellent tax deferment strategy that astute investors use with great success.

Capital gains tax

When you sell an asset for more than what you got it for, you are assessed to pay between 15% to 20% of your earnings to the IRS. A married couple filing jointly with a taxable income of $77,200 – $479,000 needs to pay 15% in capital gains. Couples that jointly earn over $479,000 would be in for 20% in taxes. But the huge tax hit on the sale of your home in the California real estate listings can go down to zero with the 1031 exchange.

Section 1031 exchange

Under section 1031 of the IRS Code, you must rollover your investment from the sale of your property in full in a 1031 exchange. You can sell one investment and reinvest the proceeds without taxation in a "like-kind" exchange where the properties must be of similar value.

If there is a difference in value between the property you sold and the one being purchased in the exchange, this is called a cash boot. Simply put, if the replacement property is of lesser value than the property sold, any cash retained by you from the sale of the old property will become taxable.

In a Section 1031 exchange, you can put up your apartments for sale in California and purchase a duplex in their stead, replace a single-family rental property for a commercial office building, or exchange a rental property or vacation rental for a restaurant space, among other similar options. Keep in mind, though, that both real properties you’re dealing with must be located in the United States and are meant for commercial use. 

1031 exchange deadlines

All 1031 exchanges are constrained by a strict deadline of six months. You have 45 days from the date of sale of your property to identify potential replacement properties you propose or intend to buy. 

During the 45-day period, you will need a qualified and reliable intermediary to come in and hold on to all documents and sale proceeds as you search for a fellow property owner willing to make the swap. They will act on your behalf in dealing with the other party. This is precisely why there is an emphasis on the intermediary’s reliability in conducting such transactions.

An entire 1031 exchange transaction should be completed within 180 days. During that time frame, negotiations with the swapping party should be concluded and deeds of sale transferred.

1031 exchange experts advise that even before officially going through the process, you should be able to identify the property owner with whom you will be swapping properties. That way, deadlines can easily be achieved and negotiations will be less tedious.

1031 and estate planning

Another advantage of participating in a 1031 exchange is that it is the gift that keeps on giving – even beyond the grave. You can conduct 1031 exchanges throughout your entire life without incurring any tax debt. Moreover, when after death your heirs inherit property that you obtained through a 1031 exchange, its value is stepped up to current market rates, essentially wiping out any possibility of having to pay taxes.

It’s best to consult with an estate planner to take full advantage of this opportunity.

A final word

Despite the many complexities of a 1031 exchange, in the end, you get the valuable prize of not being required to pay sizeable capital gains taxes for the sale of your investment property. 

To maximize the benefits of your exchange, choose your replacement property (or properties) wisely. Invest in properties with a strong potential for future growth. 

Investors would be well-advised not to act alone. Anyone considering a 1031 exchange should have a competent professional assist him through every step.

For the best advice on going through a 1031 exchange, you only have to reach out to The R&Z Group of Marcus & Millichap, your trustworthy team of Realtors in California. Call us at 650.391.1758 and 650.391.1781 or leave us a note here

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