Real estate other than your primary residence is often considered an investment. When it comes time to sell items held for investment purposes, capital gains taxes are due on any profit. Although Florida does not have income tax and hence no capital gains tax, the federal government (Internal Revenue Service) does.
Those seeking to grow their investments use a strategic approach, often to avoid paying capital gains taxes, when planning to sell assets. A business attorney with 1031 exchange experience can help you navigate a path through to your desired outcome.
What is a 1031 Exchange and How Does it Work?
There are several ways to sell an investment and avoid the full impact of capital gains taxes, which can be as high as 20 percent for selling an asset held for a brief period. Tax avoidance strategies include selling in installments, planning for the income from a sale to hit during a year of otherwise low income, investing in a qualified opportunity zone, creating a donor-advised fund, and a 1031 exchange.
Through the 1031 exchange, the IRS allows investors to sell a property and buy another while deferring capital gains because it is assumed they’re investing in the new property.
A 1031 exchange is best deployed as part of a long-term financial planning strategy that considers all of your assets and goals. Employing a team of financial advisors, accountants, and real estate professionals, is recommended as the 1031 sequence must be executed in a specific timeframe and there are key thresholds to meet before an exchange is approved.
The rules of a 1031 exchange include:
- The property purchased as part of the exchange must be broadly similar to the one sold (e.g., both held as investments). This is called the “like-kind” aspect of the exchange. For instance, an investor may sell a strip mall to buy a warehouse, but cannot sell the strip mall to purchase a luxury primary residence.
- This technique can be used to sell multiple properties, or to purchase multiple properties.
- The property intended for purchase must be identified within 45 days of the sale of the investment property. This written notice must be delivered to the intermediary.
- A Qualified Intermediary (QI) must be used to hold the proceeds of the sale that will effectuate the purchase of the new property. If the owner takes possession of the funds the sale is disqualified from a 1031 exchange.
- You must close on the new property within 180 days of selling the first.
- If you are related to the owner of the property purchased, the IRS has specific requirements of both parties, including that you hold the purchased property for two years, minimum. The seller may also be required to execute a separate 1031 exchange within a specific timeframe.
- The value of the property purchased must be equal to or greater than the value of the property sold. It’s crucial to keep track of the deferred gain as well as any improvements made to the purchased property.
- The exchange must be reported on IRS Form 8824 at tax time.
Real estate or other qualifying real property are the only instruments eligible for a 1031 exchange. Stocks, bonds, inventory, securities, partnership interests, and certificates of trust may not be part of a 1031 exchange. Some agriculture-related water access rights may be part of an exchange if considered real property.
When Is the Best Time to Make a 1031 Exchange?
Knowing that one or a series of 1031 exchanges may defer capital gains for a lifetime is enticing. In fact, your heirs can be the beneficiaries of 1031 exchanges that you make now, using the “step-up” provision of inherited ownership.Planning for next year’s taxes, or for taxes years in the future, takes strategy. An experienced business attorney from WKFK Law can build your team of expert advisors to guide you through the process. Trusted professionals who know the implications of tax law and their potential impact on your goals are priceless partners.
