The Benefits of a 1031 Tax-Free Exchange

Are you a real estate investor or someone looking to exchange a vacation home or rental property for a different type of investment? If so, a 1031 tax-deferred exchange might be suitable for you. When executed strategically and under the right circumstances, 1031 exchanges can help upscale and further optimize your investment portfolio.

What is a 1031 Exchange?

Under the standard tax code (1031), you are subject to (some hefty) capital gains taxes if you have gains when you sell an investment property. These are Federal taxes that vary based on your income but can be as high as 37 percent of the gains you made on the property.

This Is How It Works in Florida

Let’s assume you PAID $100,000 for an investment property and then sold it for $500,000; you would have made a $400,000 profit on the sale of a rental property, for which you would incur almost $150,000 in capital gains taxes. That would leave you with only $250,000 to put towards another property.

Now let’s look at the same scenario using a 1031 exchange. The 1031 exchange would allow you to defer the $150,000 tax liability, giving you the full $400,000 profit to reinvest (plus your original investment of $100,000) in buying a replacement property.

It’s easy to see how a 1031 exchange allows you to build wealth faster by keeping more of your money working for you instead of going to Federal taxes. The point is not to cheat the American government by not paying taxes but to pay those taxes when it’s more suitable to your income or life situation. You can check our previous blog to learn more about Ways to Minimize Real Estate Capital Gains Taxes.

Qualifying Property for a 1031 Exchange in Florida

In Florida, properties that qualify for a 1031 exchange must have been held for business or investment purposes. You must then purchase a property considered a “like-kind” exchange to reinvest the proceeds in a new property of equal or higher value and maintain similar loan amounts, if applicable. In the Sunshine State, land always qualifies as being held for investment purposes. Commercial properties (not the actual business) can also be eligible. Properties with rental activity are considered income-producing properties (owned for business purposes).

There are also time pressure restraints in 1031 exchanges. From the day you sell your investment property, you have 45 days to identify the potential replacement property/ies you wish to purchase and 180 calendar days to acquire and purchase/close on your replacement property (180 days total). There are no exceptions or extensions given, so time is of the essence.

Flips Need Not Apply

1031 exchanges are based on long-term investments. If your goal is to buy, renovate, and sell a property quickly (i.e., “Flip”), the property would not qualify for a 1031 exchange. Properties held for short-time investment are considered by the IRS to be inventory rather than investment. One way to transition it to a qualified investment property would be to rent the property at market value, making it income-producing. You can also hold onto the property for at least one year and a day to reach the long-term capital gains tax rate. To qualify, you might also need to establish other circumstances, such as rental history and depreciation for your fixer-upper or flip.

In short, there are tax details for flippers to be aware of, and the best solution is to consult a CPA early in your flipping and investment planning.

Vacation Homes and 1031 Exchange

As one of the most experienced vacation home Realtors on Florida’s Gulf Coast, we often get asked about vacation homes and 1031 exchanges. “You may be able to do a 1031 exchange on your vacation property if you meet specific requirements for ownership and use.

1. First, you must have owned your vacation home for at least 24 months immediately before the exchange.
2. Likewise, for a replacement property to qualify, it must be held for at least 24 months after the exchange.
3. At least once a year in those two years, you must rent your vacation home at fair market value for at least 14 days.
4. Likewise, you must not have occupied the property for personal use for more than 14 days or 10 percent of the number of days the property was rented out, whichever is greater.

A 1031 exchange likely ’is not a good solution for a vacation home you plan to use often for your own getaway. Vacation properties, however, can be turned into investment properties later and qualify for a 1031 exchange by following the same rules listed above.

Reinvestment Requirements

The cost of your replacement property must be equal to or greater than the net sales price of the property you sold to take advantage of the full benefit of a 1031 exchange. For instance, if you sold a beachfront rental property for $950,000, then to have a valid 1031 exchange, you must spend at least $950,000 to purchase one or more replacement properties. The combined reinvestment should be equal to or greater than the net sales price of the investment property you sold. If the replacement only equals a proportion of the original investment, your capital gains taxes will be calculated based on the difference (the funds you keep).

It is also important to note that 1031 exchanges are tax-deferred and not tax-free. If you eventually decide to sell your replacement property, you will have to pay the previously deferred taxes unless you roll the proceeds into another 1031 exchange.

Required Use of a Qualified Intermediary

A certified Qualified Intermediary (QI) (also called 1031 facilitators, agents, or exchangers) is required by the IRS to navigate this process for you. The QI is a neutral third party who does not have any relationship with you. The QI must be a qualified individual/company that is in the business of being an intermediary, can act as the escrow agent, and does not have any connection to the sale. The QI drafts all required documents, holds and safeguard sales proceeds, helps you meet all statutory deadlines, and guides you through the process.

Personal Realty Advisers 1031 Exchange Guidance

Broker/Owner Robert Coscia is a Certified 1031 Exchange Realtor qualified in advanced 1031-exchange strategies and the unique structures and financing considerations these exchanges create. With 30+ years of experience representing real estate investors along Florida’s Gulf Coast, we have established a network of top professionals in the legal and financial planning arenas who can guide you through the 1031 exchange process. We can recommend an expert who can help you keep a more significant portion of your investment working for your benefit.

Let us know how we can help. To learn more, visit www.personalrealtyadvisers.com or call us at 727-317-SOLD.