If you own any commercial or investment properties and you want to sell, you have a problem, especially if you make a good profit on the transaction. The problem lies in the fact that you’ll be hit with a hefty capital gains tax bill – and there goes all the money you made on the sale. But savvy investors and home sellers know a legal way around the capital gains problem: a 1031 exchange. So let’s take a look at the potentially huge tax advantages of a 1031 exchange for Los Angeles home sellers.
What Is a Section 1031 Exchange?
Here’s a succinct definition from top investing pros: “A 1031exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.”
Also known as a like-kind exchange or Starker, a 1031 exchange is basically a swap of one investment property for another. Most property swaps are taxable as sales, but “if yours meets the requirements of 1031, you’ll either have no tax or limited tax due at the time of the exchange.”
What this amounts to is changing the form of your investment without doing anything the IRS would perceive as cashing out or realizing a capital gain. The main benefit here is that your real estate investment can keep growing in a tax-deferred fashion. Also, there’s no limit on the number of times or how often you can do a 1031 exchange. You can just keep rolling the gain from investment property over to another and another and yet another.
The tax advantages of a 1031 exchange for Los Angeles home sellers, according to investing experts, consist in the fact that while “you may have a profit on each swap, you avoid tax until you sell for cash many years later. Then you’ll hopefully pay only one tax, and that at a long-term capital gain rate (currently 15% or 20%, depending on income – and 0% for some lower-income taxpayers).”
While it’s harder than it used to be, you can use a 1031 for vacation homes. And although this is for investment properties and not for swapping your primary residence for another home, there is a workaround. (Your agent can explain this in-depth. Just call 562-881-9811.)
The Intermediary in a 1031Exchange
The proceeds from a real estate sale are taxable. That’s why in a 1031 exchange, the proceeds don’t go to you (and from you to the owner or “seller” of the property you’re buying/swapping for), but rather to a qualified intermediary, who then transfers the proceeds to the “seller” of the replacement property in the swap. That’s what makes it a swap instead of a sale.
“A qualified intermediary is a person or company that agrees to facilitate the1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. The qualified intermediary can have no other formal relationship with the parties exchanging property.”
1031 Exchange for Investors
There are several scenarios in which a 1031 exchange will benefit real estate investors who want to sell a home in Los Angeles:
- Seeking a property with better return prospects
- Desiring to diversify investment assets
- Exchanging a property that the investor has to manage for a managed one
- Consolidating properties for estate-planning purposes
- Resetting the depreciation clock
Using a 1031 Exchange for a Residence Swap
As we mentioned, a 1031exchange is designed for investment properties, but there is, in fact, a workaround for residences and primary homes. And that is the 2008 “safe harbor” rule, which you can invoke if you don’t move into the home right away. Here’s what the pros say you have to do:
“You must rent the dwelling unit to another person for a fair rental for 14 days or more.
“Your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period the dwelling unit is rented at a fair rental price.”
Other conditions that obtain include:
- The swap has to be like-kind properties.
- “[Y]ou can’t immediately convert the new property to your primary home and take advantage of the $500,000 exclusion.”
- “[I]f you acquired property in a 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange.”
The Best Way to Realize 1031 Exchange Tax Benefits
It’s easy to see then that there can be some significant tax advantages of a 1031 exchange for Los Angeles home sellers. What’s not so easy to see is how it all works out and exactly how to take advantage of those tax benefits. That’s where your qualified local real estate agent comes in – to guide you through that thorny tangle of legal and financial jargon.