A 1031 tax-deferred exchange is an excellent way to delay the payment of capital gains on the sale of your property. The number 1031 refers to a section of the tax code of the Internal Revenue Service. However, it is not as simple as it reads, but it is an excellent way to delay paying taxes. And although it is not a good idea for all real estate investors, it may be a good fit for you. The following are a few things you should know about it.
It applies to most rental properties but with exceptions
If you sell a rental property, you are likely eligible for this tax deferment. But it doesn't apply equally to all rental properties. There are special rules for vacation properties, and although single-family homes are included, they cannot be your former residence. Properties that are categorized as atypical are not necessarily excluded, but they can be complex. So if you own a property like this, you will certainly need to consult with a tax accountant.
You need an intermediary
Although they're called exchanges, it seldom works out that two people are ready to swap properties at the same time. For this reason, when you sell your property, the money passes to a third party. Without this, you would owe taxes because you had income from the sale. From the time you make the sale, you will have a specific amount of time to designate which property or properties you are thinking about buying. After this, there is a specific amount of time to close the deal on your purchase. If you miss these deadlines, you will owe tax on the sale.
You may still owe tax after an exchange
There are several reasons this can happen. One common example is when the new property you are buying is worth less than the one you just sold. You will owe tax on the difference between the two. You can avoid this with a purchase of real estate worth more than the one you sold. However, there are also subtle ways you can end up owing tax. One example of this is by not figuring in the outstanding mortgage debt. If you end up with a mortgage that is less than the mortgage you owed on the last property, the IRS will consider this income from the sale of the property.
The government passed this law to encourage real estate investors to continue investing their money into more property. This is an attempt by the government to offer an incentive to real estate investors. However, the process can be complex. It does not apply to all rental properties, and you will need a qualified third party for the process. And even then, you may owe taxes when the swap is complete. Make sure you consult with a tax accountant before going through with a single-family tax-deferred exchange.