Erin Hadary MBA, CFP®, CAP® | Partner
Real estate can be an excellent investment opportunity for those who want to diversify their portfolio. But capital gains taxes can eat into your proceeds when you sell a property. “Capital gains” is the profit that results from a sale of capital assets, such as real estate, stocks, or bonds. A 1031 exchange, named for section 1031 of the U.S. Internal Revenue Code, allows you to defer the capital gains taxes that you’d typically have to pay when the sale price of a property exceeds the purchase price.
A 1031 deferred tax exchange, often called a like-kind exchange, is subject to specific rules: you must reinvest in a property of equal or greater value to avoid current taxation on part of the gain, and you need to close on that property within a set period after the first property is sold. A 1031 exchange gives you an advantage of freeing up more capital to leverage in the real estate market. However, it’s not tax-free — capital gains taxes are simply deferred until the day you sell your purchase property.
Rules for a 1031 Deferred Tax Exchange
There are several IRS guidelines that investors must follow to comply with the regulations for 1031 exchanges. Here are some of the conditions your transactions must meet to qualify as a 1031 exchange:
- “Like-kind” properties: The property you’re selling and the property you’re buying need to be similar in nature and used for business or investment purposes. You can’t buy or sell your personal residence in a 1031 exchange. Generally, real property (not held for sale) is considered like-kind to other real property, though real property in the United States is not like-kind to real property outside the United States.
- Equal or greater value: The property you’re purchasing needs to have the same (or greater) value as your current property if you want to defer all the gain. Otherwise, if you receive non-like-kind property such as cash or net debt relief, you will owe gain up to the amount of non-like-kind property received.
- Qualified intermediary: You’re not allowed to touch the proceeds of your property sale if you want to use a 1031 exchange. If you are going to receive property after the transfer of the property given up in a deferred exchange, you must work with a qualified intermediary (QI) who will hold the sale proceeds during the 180-day timeline and hand them off to the seller of the purchase property. In Colorado, your QI must have your authorization to withdraw sale proceeds exceeding $250,000. They are required to have an insurance policy that includes $250,000 in errors and omissions insurance and a fidelity bond of $1 million or more. Finally, they must state in writing how they will deposit and invest your exchange proceeds.
- Timeline: It’s important to decide that you want to do a 1031 exchange (and identify a QI) before you put your sale property on the market. Once you’ve sold the first property, you have 180 days to close on the sale of a replacement property (or the due date of your tax return (with extensions), if earlier, so it may be important to extend your tax return depending on your timing). Within the first 45 days of that 180-day timeline, you must officially identify potential “replacement properties” that you would like to buy. If you don’t meet these timeline rules, the transaction does not qualify for 1031 tax deferral.
How Does a 1031 Exchange In Colorado Benefit You?
Utilizing a 1031 exchange doesn’t mean you’re exempt from paying taxes. But it does allow you to defer capital gains tax payments, freeing up more capital for you to invest in a higher-value property. The process also allows you to diversify your real estate portfolio. Even though you’ll need to purchase a “like-kind” property, there’s some leeway within that category for different types of business or investment property.
If you’d like to diversify by increasing the number of properties you own, a 1031 exchange allows you to do that, as well, using one of these rules:
- Up to 3: This rule allows you to identify up to three alternative replacement properties (regardless of their fair market value).
- 200% rule: This rule allows you to identify an unlimited number of properties during your 45-day window, as long as the cumulative market value does not exceed 200% of the aggregate fair value of the property you’re relinquishing
- 95% rule: This rule allows you to identify an unlimited number of properties during the 45-day window, as long as you close on 95% of the aggregate fair market value of the identified properties.
Get Expert Real Estate Investment Advice from Moneta
While this process can give you significantly more capital to work with, if you don’t understand the Colorado 1031 exchange rules, your exchange could be void and you’ll need to pay capital gains tax. Make sure you’re working with a trusted investment advisor who is familiar with the intricacies of real estate investment. At Moneta, the Hadary Team provides personalized investment advice for property owners and real estate investors in Colorado. To learn more about our services, book an appointment today.
© 2022 Moneta Group Investment Advisors, LLC. All rights reserved. These materials were prepared for informational purposes only based on materials deemed reliable, but the accuracy of which has not been verified. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. These materials do not take into consideration your personal circumstances, financial or otherwise. The information contained herein is subject to change and is not intended to be comprehensive or exclusive. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision.
