How a 1031 Tax-Deferred Exchange Saves Money on Your Seattle Investment

If you own an investment property or plan on buying one, you want to maximize the profits you can make off the properties you own. So, let’s talk about how a 1031 tax-deferred exchange saves money on your Seattle investment.

A Review of Capital Gains Tax

To understand just how a 1031 exchange saves you money when buying a new investment property, let’s quickly go over what capital gains tax is. In short, it’s taxes you pay when you profit from selling an investment you’ve held for at least a year. For example, when you sell off some stocks you’ve had for a while, the profit you make is called a capital gain. Based on the tax bracket you fall into that year, you’ll have to pay 0%, 15%, or 20% of those gains to the IRS.

Short-term capital gains, or those earned from investments held for less than a year, are taxed as ordinary income.

What a 1031 Exchange Is

People who invest in real estate often find it beneficial to sell one investment property to buy another one. Under normal circumstances, selling an investment property would incur capital gains tax. But the IRS does allow people to defer paying capital gains when they’re selling one property for the purpose of buying another. This is called a like-kind exchange or 1031 tax deferred exchange. It allows you to use all your profits from the sale of one rental property to purchase a new one.

A 1031 exchange simply defers the capital gains from selling your investment property. It does not cancel it out. When you eventually cash out by selling a rental property without purchasing a new one, you will have to pay taxes on whatever you earned from that final property. That said, you can do as many 1031 exchanges as you want, continuously swapping investment properties and delaying the capital gains taxes on the sale of the older ones.

Why You May Want to Use a 1031 Exchange

There are several reasons why an investor might want to consider a 1031 exchange:

1. Consolidating several properties, or dividing a single property into several
2. Switching to a managed property rather than managing it yourself
3. Diversifying assets
4. Switching to a property with better investment return prospects
5. Resetting the depreciation clock

A tax professional can help you better understand in which situations a 1031 exchange would be most beneficial—it isn’t right for all investors.

Rules for a 1031 Exchange

Anyone who owns an investment property is eligible for a 1031 exchange. But to ensure yours goes through without a hitch, there are some stipulations you’ll need to adhere to. They can be pretty specific to certain situations, so if you plan on making a like-kind exchange, you should definitely consult a professional throughout the process.

Here are some things to keep in mind:

Both properties must be owned for investment or business purposes only. The one you’re selling is allowed to have been your primary residence at some point, but it must be an investment property at the time of the exchange.

You can use a vacation home for one of these property exchanges, provided that you’ve recently rented it out for a lengthy period of time without reoccupying it yourself.

You’ll need what’s called a qualified intermediary—or QI—to initially receive the money from the sale and then transfer it to you. The QI is typically a banking or legal professional, accountant, or real estate broker.

After selling the original property, you have 45 days to identify the replacement property and 180 days to complete the purchase.

The property—or properties—you identify must fall under specific categories that meet one of three rules:

1. Three Property Rule, which is when you pick out three properties as potential replacements with no restrictions on their market values.
2. 200% Rule, when you can choose as many potential replacement properties as you want as long as their combined value is less than 200% of the value of your current property.
3. 95% Rule, which allows you to have as many potential replacements as you like, as long as they’re valued at least at 95% of their total value.

What You Need to Know About Form 1031

The 1031 form that you need to conduct a like-kind exchange has four parts, but not all are likely to apply to most situations. And the first part, Form 8824, is arguably the most important and most asked-about section.

1. Part I (Form 8824): The first section, also known as Form 8824, is where you must provide all relevant information about both the property you’re selling and the one you’re purchasing.
2. Part II: This section is for exchanges that involve family members or partners in entities you have a controlling interest in.
3. Part III: The third part of Form 1031 is where you report all monetary gains or losses from the exchange to the IRS.
4. Part IV: This section is necessary only for federal employees with possible conflicts of interest that need to be addressed.

Put All Your Profits to Work for You

Now that you know exactly how a 1031 tax-deferred exchange saves money on your Seattle investment, you can start thinking about making use of one. 

1031 exchanges should always be handled by a professional, so we recommend that you consult with an accountant before making any decisions.

If you have any questions about buying an investment property in Seattle, give us a call at 206-353-7625 or connect with us here! We work with investors all the time and are happy to help answer any questions you have (or maybe even start looking for that perfect property).