Anyone trying to sell an investment property and buy a new one for a similar price should consider the benefits of a 1031 exchange. The primary advantage is that you won’t have to pay capital gains tax on the sale of your current property, which as you know can add up to a pretty big sum of money when you’re dealing with large commercial properties. The exchange also provides other write-offs and gives you even more incentive to find a worthy replacement property.
Although the benefits of a 1031 exchange are obvious to anyone who knows about the process, some investors automatically assume that this tax deferral option will be around forever, or that performing a 1031 exchange is simple enough for anyone to do. To the contrary, there are lots of steps to the process, and the replacement property also has to meet certain qualification requirements. With that said, here are four things to keep in mind if you’re currently pondering the idea of a 1031 exchange:
1. You’ll Need to Find an Eligible Exchange Property
The first thing to be aware of is that you can’t just buy any type of property to replace your current investment property with. It’ll need to have a similar value, purchase price, and mortgage amount as the property you currently own, and it may need to fit other criteria as well, depending on the type of transfer you’ll be conducting. For this reason, it’s best to seek the advice of a professional when choosing a 1031 exchange property.
It’s also worthwhile to search sites that specialize in listing properties that are eligible and open to 1031 exchanges. This will make it easier to match up with the right seller if you intend to do a simultaneous exchange. However, a property doesn’t have to be listed or advertised as being qualified for a 1031 for it to be so.
2. 1031 Exchanges Might Not Be Around Forever
Investors and real estate experts tend to take the 1031 for granted, advising clients to be patient and wait for the right property. Although that’s certainly sound advice in many cases, there’s also a risk that 1031 exchanges could be repealed or the process could be changed radically. The best way to ensure that you won’t have to pay capital gains tax on the sale of your property is to sell it and conduct the 1031 exchange as soon as possible.
Of course, it’s still advised that you exercise caution and discretion when selecting a property and finalizing the deal, but it’s also wise to have a sense of urgency about it, knowing that there’s no guarantee that the 1031 exchange tax deferral program will last forever. If the rule is changed or repealed next year, you’ll undoubtedly be regretting that you didn’t sell your property and file the exchange this year.
3. You May Need Professional Assistance
Although a 1031 exchange seems like a straightforward process, there are actually a number of technicalities involved. You’ll be filling out some paperwork for the IRS, and you want to avoid any errors or oversights; therefore, it’s best to have someone experienced in the matter to help you complete the process. If you attempt to go it alone, you could wind up making mistakes that lead to an audit or worse, so saving a little bit of money to do it independently usually isn’t worth the hassle. This is especially true if it’s going to be your first 1031 exchange.
You don’t want to jump into something you’ve never done before without anyone to guide you along the way. The good news is that with the money you’ll be saving on capital gains tax and other fees, you should have no problem shelling out a small portion of those savings to a professional who will keep everything simple and error-free for you.
4. There are Multiple Types of 1031 Exchanges
The last thing you’ll need to know is that there are several ways to go about conducting a like-kind exchange and reporting it for the tax deferral. The most common is a delayed exchange, during which the investor sells their current investment property, and then has a certain amount of time after the closing to select and purchase the replacement property. Another common type is the simultaneous exchange, in which two investors with similar properties essentially trade one property for another on the same day.
A reverse exchange takes place when the investor buys the replacement property before selling their old property, but then still reports it as a 1031 exchange. These are all legal options provided the sales are recorded properly, and the appropriate paperwork is accurately filled out. Before committing to the steps involved, it would be wise first to determine which type of exchange would best suit your needs, preferences, and schedule in the near future
5. Choosing the Right Property is Paramount
In closing, always remember that property selection is by far the biggest thing for you to focus on as the investor. All the other details and tasks can be delegated to capable help, and you shouldn’t have to worry too much about it, but the act of selecting and approving the property is ultimately your responsibility, so that’s where most of your effort should be allocated. Choosing the wrong property could wind up being one of the biggest regrets of your life, especially if you’re unable to sell it for the same price or more than what you bought it for.
Nobody likes losing on an investment, so as an investor your primary concern should be choosing the right investment for the exchange – otherwise the entire process is a moot point. Who cares about saving on capital gains tax if you’re trading your current property for one that’s not even going to perform as well as the previous? The idea is to not only save on taxes, but also to upgrade as well.