If you are considering leaving an investment property to your loved ones, a 1031 exchange may be a useful estate planning tool for you. Because these exchanges allow you to defer taxes or limit the taxes owed on a sale, you can use the money that would have been spent on taxes to increase your property portfolio, rental income, and personal wealth.
What is a 1031 exchange?
A 1031 exchange is a process in which you exchange one investment or business property for another, thereby deferring capital gains taxes on the profits you make from selling the first investment property. Although you are not avoiding capital gains, you can defer a significant portion of capital gains taxes due in the future. However, you must follow specific rules for a sale and a purchase to be considered a 1031 exchange.
A 1031 exchange will be recognized by the Internal Revenue Service as long as the transaction meets specific criteria:
1. The main requirement is that the properties being exchanged are both investment properties, whether or not they are the same type of property (eg apartment, building, multi-family property, etc.). There are also special rules regarding holiday homes.
2. Second, the money from the sale of the first property must be held by a “qualified intermediary” until the second property is ready to be purchased. A qualified intermediary is a third party who escrows funds until a new property is ready to be purchased. You cannot receive funds at any time from the sale of the first property and the subsequent purchase of an exchange property. Thus, it is crucial to use a trustworthy and reputable company.
3. Third, the exchange must take place within a specific time frame. You must designate, in writing to the intermediary, the properties that interest you within 45 days of the sale of your first investment property. You then have 180 days to finalize the purchase of the exchanged good.
The exchange process 1031 can be carried out consecutively with no limit on the number of transactions, as long as they are all carried out correctly. This means that many people can defer capital tax for very long periods of time.
When you finally decide to sell your traded property for cash, you will pay taxes at the long-term capital gains rate. This can be much less than other tax rates. For example, in 2022, the tax rate is 0%, 15% or 20%, depending on a person’s taxable income.
1031 Exchanges and estate planning
You may not realize that 1031 exchanges can be a valuable estate planning tool. For example, if you die without ever selling your replacement property, your heirs will inherit it at market value. Your loved ones will not have to pay capital gains tax on the appreciation in the value of the property.
Before determining if a 1031 exchange is right for you, there are additional intricacies and rules to consider. If you’re considering a 1031 exchange as part of your estate planning process, it’s a good idea to speak with an attorney in your area.