A Guide to 1031 Exchange Basics

Tuesday, December 14, 2021

Want to know the crafty loophole real estate investors use to avoid paying taxes? A 1031 exchange helps investors accumulate significant wealth without paying capital gains taxes. 

This investment opportunity is exclusive to real estate. You won't find the same luck trying this strategy in the stock market.

Once you learn the rules, you can conduct 1031 exchanges and never pay capital gains on any investment property. Read on to learn how 1031 exchanges work so you can defer your capital gains.

Each Property Must Be An Investment Property

A 1031 exchange in Houston requires that both properties are similar in nature. While the terminology suggests you can only trade in a duplex for another duplex, you can tap into a broader range of investment properties.

You can sell a duplex and use those proceeds to buy land or an apartment. While a duplex is a different asset from the other two, this is simply the exchange of one investment property for another. Under these guidelines, a 1031 exchange will defer your taxes.

You cannot conduct a 1031 exchange if you swap the investment property for your personal vacation home. The IRS will not consider your vacation home as an investment property for 1031 exchange purposes. Your primary home also won't work for a 1031 exchange.

If you decide to live in your investment property, you must wait at least a year. During that year, you can only live in the property for 14 days. You must also rent the property to another person for at least 14 days.

If you fulfill those conditions within the first year of owning the investment property, you can turn it into a primary residence or vacation home.

The Price of The Investment Property Determines Your Savings

Not every 1031 exchange is tax-free. If your new investment property

costs less than your initial investment property, you will get taxed on the difference.

Let's say you sold a $500,000 duplex. If you use only those proceeds to buy a $300,000 single-family home, you will get taxed for the remaining $200,000. 

If you bought another single-family home and used all of the proceeds from the duplex for both purchases, you can defer all of your capital gains taxes.

Timeframe for Implementing a 1031 Exchange

Real state investors have a limited timeframe to implement a 1031 exchange. They must identify a suitable investment property within 45 days of selling their initial investment property. The investor must finalize the exchange within 180 days of selling your prior investment property.

Due to this timeframe, it's essential to look for an investment opportunity before you sell. Starting your investment property search now will reduce the stress of abiding by the 1031 exchange deadline.

If you want to sell a property in the Houston area,

start looking at various counties. Decide where you will focus your property search well before you finalize the sale of your initial property.

Build Your Real Estate Empire

Buying your first investment property is exciting. However, as you add more properties to your portfolio, the work will get challenging.

Real estate investors often spread themselves too thin and stop growing too early.

As you scale, you should consider a property management company to assist existing tenants and find a tenant for your next investment property.