Being a real estate investor comes with many rewards. It’s a good way to buy and sell properties for income. And in a hot market you can make a quick turnaround for a substantial profit.
But with any investment that brings additional income, it can also be very costly when it comes to tax time.
What can you do to help lessen some of the tax burden?
There’s a tax strategy that helps real estate investors balance out the income tax issue. It’s called the 1031 exchange.
A 1031 exchange is a tax deferral strategy that allows real estate investors to sell one property and use the profits from that sale to purchase more income producing properties.
It allows investors to avoid paying any capital gains tax on an investment real estate property if they reinvest the profits into another similar property within a certain amount of time.
Which can be a powerful wealth building tool because your 1031 exchange deferrals can continue through as many exchanges as you wish.
But there’s a lot of rules and guidelines you need to follow in order to qualify using the 1031 exchange.
As a real estate investor you need to follow basic guidelines and specific deadlines in order for your properties to qualify as a 1031 exchange.
Any shortcuts could lead to an unfavorable tax day surprise.
Here are the basic steps to completing a 1031 exchange:
1. Identify the property you want to sell.
2. Hire a Qualified Intermediary (QI)–You should have an QI before starting the process.
This is a professional that actually executes the exchange. A QI holds the proceeds from the sale of the property in escrow until you are ready to reinvest in a replacement property.
There must be a written exchange agreement between you and the QI to avoid receiving a constructive receipt.
3. Replacement Property-Must be a “like-kind” of property of equal or greater value of the property you’re selling. This property must be held for productive use in a business or for the sole purpose of investment.
4. Add Relinquished Property to Addendum-Any property you are relinquishing should be added to any offer you get. This allows you to assign the contract directly to your QI and makes it clear that you’re intending to complete a 1031 exchange of the property.
5. Provide a copy of your sales contract immediately to your QI.
6. Decision of Property-When you decide on which property you plan to buy, execute a contract on it and send it to your QI. You QI should walk you through the step of assigning the contract for the new property you’re purchasing.
7. Time Limit-You have 45 days to identify your potential replacement property once the sale of your original property is settled and close on the new property within 180 days from the sale of your original property.
8. File IRS Form 8824-This reports the 1031 exchange with your tax return.