A 1031 exchange 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.
As mentioned, a 1031 exchange is reserved for property held for productive use in a trade or business or for investment. This means that any real property held for investment purposes can qualify for 1031 treatment, such as an apartment building, a vacant lot, a commercial building, or even a single-family residence.
The motivation to use a 1031 exchange can be substantial. This is because investor capital that otherwise would be paid as capital gains tax is rolled over as part of the down payment into a replacement property. This provides greater investment benefits than the sold property.
While the benefits of 1031 exchanges are plentiful, there are a few disadvantages to be aware of before you start exchanging all of your investment properties:
Feb 5, 2021
If a property has been acquired through a 1031 Exchange and is later converted into a primary residence, it is necessary to hold the property for no less than five years or the sale will be fully taxable.
Yes, all forms of land, including undeveloped land, are eligible for a 1031 exchange. However, if you plan to buy a vacant lot, develop it, and benefit from its sale after a tax-deferred exchange, then it is not eligible.
If you file as an individual, your Social Security is not taxable only if your total income for the year is below $25,000. Half of it is taxable if your income is in the $25,000–$34,000 range. If your income is higher than that, then up to 85% of your benefits may be taxable.
How to Minimize or Avoid Capital Gains Tax
The Internal Revenue Service allows exclusions for capital gains made on the sale of primary residences. Homeowners who meet certain conditions can exclude gains up to $250,000 for single filers and $500,000 for married couples who file jointly.
Profit from the sale of real estate is considered a capital gain. However, if you used the house as your primary residence and meet certain other requirements, you can exempt up to $250,000 of the gain from tax ($500,000 if you're married), regardless of whether you reinvest it.
No, unless they meet certain eligibility conditions – for example, if the capital asset was purchased through an SMSF and sold in the pension phase, or the asset was acquired before 20 November 1985.
Capital gains tax is due on $50,000 ($300,000 profit - $250,000 IRS exclusion). If your income falls in the $40,400–$441,450 range, your capital gains tax rate as a single person is 15% in 2021. (The income range rises slightly, to the $41,675–$459,750 range, for 2022.)
In the interest of avoiding capitals gains tax, you'll need to live in the property for a minimum of six months for it to be considered your main residence before moving out and using it as an investment property.
You may qualify for the 0% long-term capital gains rate for 2021 with taxable income of $40,400 or less for single filers and $80,800 or less for married couples filing jointly. You calculate taxable income by subtracting the greater of the standard or itemized deductions from your adjusted gross income.
You're eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods.
You can avoid a significant portion of capital gains taxes through the home sale exclusion, a large tax break that the IRS offers to people who sell their homes. People who own investment property can defer their capital gains by rolling the sale of one property into another.
2022 Capital Gains Tax Rate Thresholds
|Capital Gains Tax Rate||Taxable Income (Single)||Taxable Income (Married Filing Separate)|
|0%||Up to $41,675||Up to $41,675|
|15%||$41,675 to $459,750||$41,675 to $258,600|
|20%||Over $459,750||Over $258,600|
The 2-out-of-five-year rule is a rule that states that you must have lived in your home for a minimum of two out of the last five years before the date of sale. However, these two years don't have to be consecutive and you don't have to live there on the date of the sale.