Many people find themselves paying into an investment property that they purchased a while back but not being satisfied with the results they’re getting. Unfortunately, just picking up and moving to another location isn’t just cut and dry, sell and buy. There are lots of things to be considered – such as the taxes and technicalities involved.
If you’ve been considering moving your money to a new investment by selling your current property and buying a new one, you might have been discouraged by the fact that you’d have to pay taxes on the sale and the purchase. Many people find that taking such a loss is worth getting out of the current investment and into a new one, because sadly they’re not even aware that there is a tax deferment program that will let you get around this.
With that said, here’s all you need to know to get out of one investment property and into another without paying an exuberant amount of taxes:
1. Research the 1031 Exchange
The 1031 exchange, also called the Starker Exchange, is a transaction in which you sell one investment property and purchase another of “like-kind” in order to defer paying capital gain taxes on the sale. There are many rules for qualification, but generally the main requirement is that the replacement property is of the same value and that the new mortgage loan is of a similar amount.
For example, if your existing investment property cost $1 million and your mortgage loan covered $750k of it, then the new 1031 exchange property would have to cost about $1 million with a loan of $750k. Now that you’re aware of this type of exchange, be sure to research it thoroughly in your spare time before committing to it.
2. Know When a 1031 is a Good Idea
A 1031 is a good idea whenever you’ve invested a lot of money in an investment property and have no desire to continue the battle with it. At that point, you’re not only losing money but you’re also pouring your time and effort and a property that you don’t even want to keep.
A 1031 is even more appealing if your property has increased significantly in value since you purchased it, as then you stand to not only switch investments but also make a decent profit in the process.
It would be highly unfortunate to be stuck with it simply because you know you’re going to lose some of the equity when you sell due to taxes. Thus, the 1031 program was created to give investors the option to swap investments more freely without being taxed excessively each time.
3. Find the New Property
Once you’ve decided you’re going to utilize the 1031 deferment program, the next step would be to start looking for 1031 exchange properties to see if you can find one that you’re genuinely interested in. After all, there’s no sense in taking the next steps if you aren’t sure you want to go through with the process. So before proceeding, look at some other properties that would qualify for the exchange and see if you’re still interested in exiting your current investment.
4. Exchange Your Current Property for One in Equal Value
Before you sell your current property, you’ll want to be sure you have the process set up properly. This primarily will entail selecting the right property, as the approval of the 1031 exchange tax deferment will depend mostly on this factor. As mentioned, the property must be of the same value and the loan amount must be the same as well, so keep that in mind as you’re searching for a replacement property. Of course, you’ll also want to look for signs that it will be more profitable than your current property.
5. Understand the Types of Exchanges
You’ll also want to choose whether you’ll be doing a simultaneous exchange, delayed exchange, reverse exchange, or construction/improvement exchange. Here are brief definitions of each to help you decide which would best suit your needs and preferences:
Simultaneous – In this type of exchange the sale of the old property and purchase of the new one occur on the same day and involves two investors essentially trading properties with each other, which is how the original 1031 exchange always went before other types were invented. However, nowadays this type is fairly rare because it is unlikely that you’ll find an investor who not only wants to buy your property but also has a property of equal value that you’re interested in buying at the same time.
Delayed – This allows you to sell your property and then buy an exchange property within a certain amount of time. Most exchanges are of this type because it allows you to collect the funds from the purchase and then use them for a substantial purchase in the near future. To do this you’ll need to be okay with having the proceeds from your property sale being held by a third-party until it is used to purchase the exchange property.
Reverse – This occurs when you purchase a property and then later sell your current property but the capital gain taxes are still deferred. This type can be difficult because banks won’t allow you to have your mortgage titled to two properties at the same time. Thus, since you’ll still have your mortgage covering the current property, you’ll either need to buy the exchange property in cash or purchase it with an LLC and use business credit to obtain a separate mortgage.
Construction/Improvement – In this type of exchange you sell your property and then purchase a replacement that is worth much less. However, you’re able to use the remaining funds to invest in the construction and improvement of the property.
Taking Advantage of the Opportunity
With changes being implemented at the government level and programs being defunded or halted altogether, there is no certainty that the 1031 program or any other will continue for years to come. Thus, it’s best to take advantage of it now while it lasts.
Plus, even if 1031 still exists 20 years from now, there’s no sense in waiting to get out of an investment that’s doing nothing but draining your funds. If you’re not motivated to revamp the place and bring in new business to rectify the situation, then follow the advice above to take advantage of 1031 exchange to press the refresh button and start over with something new.