Income Tax Deferral Strategy for Real Estate Investors
There are a variety of significant income tax benefits that are often overlooked by real estate investors that could enable them to exclude or defer some or all of their income tax liabilities on the disposition or sale of their real estate assets.
Section 1031 Exchange
Section 1031 of the IRS tax code provides that real property held for investment, rental or use in a business (“relinquished property”) can be exchanged for “like-kind” real property also held for investment, rental or use in a business (“replacement property”) allowing the Investor to defer her or his Federal, and in most cases, state income tax liabilities.
Who a 1031 Like-Kind Exchange is Right For
A 1031 like-kind exchange is best for both business owners and real estate investors. This is because the property allowed in a 1031 exchange can be either a business or real estate. However, business owners and real estate investors have different requirements they must meet in order to qualify for a 1031 exchange. Further, 1031 like-kind exchanges are much more common with real estate investing.
1031 Exchange for Real Estate Investors
If an investor is thinking of selling an existing rental property, for example, and wants to buy another like-kind property, then a 1031 like kind exchange is a great option because it allows him to defer taxes on the sale. Generally, any real estate property held for the productive use in the business or trade or for investment qualifies for a 1031 exchange.
This means that commercial real estate can be exchanged for residential real estate investments and vice versa. For example, a shopping center can be exchanged for an apartment building or multifamily property. In cases like these, investors will typically use the profits as a down payment and cover the rest of the purchase with an apartment loan or multifamily financing.
There are also 1031 marketplaces that offer different types of commercial properties and investment properties for sale that can be purchased during your 1031 exchange. So, you could feasibly exchange your investment property for a pool of investment properties and take advantage of passive income. This is attractive to investors who don’t like the hands-on approach of being a landlord.
Most long-term investors looking to execute a 1031 exchange consider a turnkey real estate property (which is a rent-ready rental with existing tenants already in place). This is beneficial for investors who want to find a cash flow positive property quickly before the 45-day identification window expires.
With a 1031 exchange there is no minimum “hold time”, however almost all properties are long-term investments so are taxed at the long-term capital gains tax rate. Although there isn’t a set hold time, a 1031 like-kind exchange is not meant for fix-and-flippers, since it’s supposed to be used on long-term investment properties.
Companies that Offer 1031 Exchange Help
Completing a 1031 like-kind exchange can be difficult so you should avoid attempting it without professional help. For example, real estate investors and business owners will typically want to work with 1031 exchange intermediaries, marketplaces and firms to help facilitate their like-kind transaction. Working with professionals ensures that you comply with the all of the IRS’s requirements.