Real estate can be a great investment, especially with all of the tax benefits. You can generally deduct interest, property taxes, repairs, and depreciation. Sometimes, a rental property may even generate a tax loss, while being cash-flow positive. But what happens when you sell your property?
If you sell your property as a loss, then you may be able to deduct the loss against your other income. Hopefully, you will have a gain when you sell your property, and you can reinvest the proceeds into another property. The flip side is that if you do have a gain, then you will end up paying Federal and possibly state income taxes.
There is a way out from not having to pay any taxes on the gain of your real estate transactions. It’s called a section 1031 exchange. A 1031 exchange allows you to postpone paying taxes on the gain if you reinvest the proceeds in a similar property. You will not have to ever pay any taxes on the exchanged property unless you sell it outright.
For example, let’s say that you own a small multi-family rental property that you are looking to sell so that you can purchase another rental property. The final sales price of your rental property is $400,000, which represents a gain of $150,000. Between Federal and state taxes you may end up owing approximately $50,000, for example, on your sale. But, if you located a property and properly executed an exchange, then you will not owe any income taxes on the transaction until you sell your newer property.
It sounds simple, but you must adhere to several important rules to make it work. First, when you sell your original property you have 45 days to find a replacement property. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. Next, the replacement property must be received no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.
Ultimately, you must work closely with your attorney, realtor, accountant, and a qualified intermediary for the outcome to be as successful as possible.
Also, 1031 exchanges are actually quite common with vehicles. Trading in your vehicle for another is considered an exchange as well, but the rules are more stringent, whereas cars are not like-kind to trucks.