Why Do A 1031 Exchange In The First Place?

If you're about to sell an investment property, the news that the money you'll receive far exceeds what you spent buying the place may sound delightful at first. Then you remember that you'll owe capital gains taxes, and the delight can dim a little. Yes, you know why you have to pay taxes, but if you hoped to use that money for other purposes, like more investments, the tax bite can hurt.

One option is to use a 1031 exchange, in which you take the money from the sale and reinvest it in another similar property within a set amount of time. This lets you avoid paying the taxes for a while, or at least until you're in a place where you feel more OK seeing all that money go to taxes. Yet questions may still remain because, if you're going to eventually pay anyway, why go through the process of doing a 1031 exchange?

Aren't You Just Putting off the Inevitable Tax Payment?

The way a 1031 exchange works is that you sell your property and buy another property within a specific timeframe. That's why it's called an exchange; you're exchanging one property for another. The taxes on the profits from the first sale are then deferred until you sell the second property, in which case you'll owe the taxes from the first sale along with those from the second sale.

What people often forget, however, is that tax rates can go down, and exemptions from capital gains can change. It could be that you're able to get a better rate on some of those taxes by waiting a few years instead of paying now. A 1031 exchange allows you to have more control over when you pay those taxes.

Is It Even Necessary?

Tax laws give taxpayers various exemptions, including one on profits made from selling a primary residence. However, 1031 exchanges cover investment properties, and while you could argue that your primary residence was an investment, whether or not the IRS will agree with you is not guaranteed. You have to assume that your investment property would not be the same as a primary residence for the purposes of avoiding capital gains taxes. A financial planner and tax accountant can help you determine which properties could be eligible for the primary residence exemption and the 1031 exchange.

Should You Do Multiple 1031 Exchanges?

You actually can do multiple 1031 exchanges, rolling over money again and again, if the exchanges are done correctly. And these are things the IRS looks at very carefully, so you really want a financial planner and tax accountant to do these exchanges with you.

For more information on 1031 DST exchanges, talk to a financial planner today.