If you purchase real estate for investment in California, you may be concerned about having to pay capital gains taxes if you sell the property and reinvest or “exchange” the funds from the sale into another investment property. Fortunately, Section 1031 of the Internal Revenue Code allows you to defer capital gains taxes in certain situations, making property investment an easier and more lucrative endeavor.
What is a Section 1031 exchange?
A Section 1031 exchange, wherein you sell an investment property and exchange it for another investment property of like-kind, is essentially a tax break because it allows you to defer capital gains taxes on the exchange. In a Section 1031 exchange, you will ultimately pay taxes only once under a long-term capital gains rate after you stop exchanging investment properties.
In a Section 1031 exchange, the proceeds from the sale of the initial investment property are kept in the hands of a third-party escrow agency and used to purchase the new investment property. You will never actually have these funds in your own hands, even temporarily. You can use this third party to hold the proceeds of your sale even if you are still looking for an investment property to buy and it will still qualify as an exchange.
In a Section 1031 exchange, the properties involved must be of “like-kind.” This rule is interpreted liberally. For example, you could exchange a farm for an apartment complex, even though these properties may seem like they do not have much in common. What is important is that the properties are located within the U.S.
Section 1031 makes real estate investment easier
If you comply with all Section 1031 rules, there is no limit on how many 1031 exchanges you can make. You can roll over gains from one investment into the purchase of a new investment as often as you need to.
Ultimately, 1031 tax deferrals can provide real estate investors with an incentive to keep investing in real estate. Still, 1031 exchanges can be complicated especially if they involve personal property or a reverse exchange. Moreover, there are important timing rules you must follow if you are making a delayed exchange.
For these reasons, many real estate investors work with an attorney when executing a 1031 exchange.
