So, what exactly is a 1031 Exchange and why do they call it that?
It’s called a 1031 because “1031” is the section of the IRS Tax code that this law originates from.
Under Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031), the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.
When you do a “1031 Exchange” you are taking advantage of a tax rule that was put in place to help people save money on taxes when they sell an investment property.
Can I do this on my primary residence, too?
If you have lived in your home for 2 of the last 5 years, a 1031 is not necessary because you are already allowed up to 250K or 500k per couple on the sale of your primary residence. So, in most cases you are not subject to a capital gains tax.
What is “capital gains”?
That is just a fancy term for the money you would make on the sale of a property…your profit!
Let’s say you buy a house for 100K.
You sell it for 200K!
Congrats! You have made 100K off your savvy investment.
The 100K is capital (money) you have gained (earned)…get it?
Now, if this house is your primary home and you have lived there for more than 2 years out of the last 5….then, no issue! You get to keep the whole 100K without paying any capital gains taxes….WooooHoooo!!!
What? You haven’t lived there for 2 years out of the 5? Uh Oh. In that case, the IRS does not consider your home a primary residence and you are now subject to on average 15% capital gains tax on any money you make on the sell of that home. Boo!!
This is where the 1031 Exchange comes in!
The IRS says that even though it’s not your primary you are selling and you need to pay taxes, IF you are going to take the money you just made and purchase another property with it then they will give you a break and not charge you. How nice of them, right?
What’s the catch?
Yes, there are some rules….
Rule #1: You can’t touch the money that comes from the sell! All proceeds from a sale will go straight to a special account and handled by what they call an “intermediary” which is sorta like an escrow co for 1031’s.
Rule #2: You have 45 days to find a new property to buy
Rule #3: You have 180 days to get the sale closed
Rule #4: The property you purchase needs to be greater or equal in value to the one you sold
Rule #5: No money is to be left over from your sale and if there is, it will be subject to capital gains taxes
What is the main benefit of doing a 1031 Exchange?
The tax savings!! The 1031 allows you to invest the money you would have paid to Uncle Sam and buy more real estate.
There’s more details to this story of course and you should always, always, always check with your tax accountant to confirm your particular circumstances since everyone is different. But, this should help you get a little more familiar with the topic.
If you are interested in selling your home and doing a 1031 Exchange, our team at Modern Real Estate Shop can help you through each step of the way!
Give us call today!