The tax benefits available to real estate investors who rent out homes are pretty great. You can reduce your tax liability by claiming depreciation, deducting mortgage interest, and taking deductions for things like maintenance, advertising costs, and professional Santa Rosa property management fees.
Another great tax break for rental property owners can be found through the 1031 exchange. With this program, you can defer any taxes that might be due when you sell an investment property. With home values higher now than they were when you bought your home, you’re likely to make a lot of money when you sell. You’re also likely to face a large capital gains tax.
Unless you re-invest the proceeds from that sale into another investment property.
The 1031 exchange is a favorable option for real estate investors when it comes to protecting income and ROI from capital gains taxes.
Here’s a complete look at what you need to know when you decide to pursue a 1031 exchange.
How Santa Rosa Real Estate Investors Can Use the 1031 Exchange
According to the current tax laws and the IRS, a 1031 exchange is permitted when an investor who has made a profit from a real estate investment or taken depreciation tax credits decides to purchase another property of equal or greater value. It has to be a similar property (the tax code calls it a “like-kind” property), and there are specific time limits that are attached to this exchange. The taxes due on the sale of the initial property are then deferred.
This is an incredibly effective tool for many real estate investors, especially when they’re trying to leverage the rental properties they currently own in order to diversify or grow a portfolio.
If you’ve thought about selling an investment property that isn’t performing the way you had hoped but you are worried about the tax burden, the 1031 exchange is your answer. You can immediately benefit from the equity you’ve built in your current property, and move that money into another property that can help you earn more. Maybe you can even afford two properties with what you earn off the sale of one.
As you move through the process of exploring a 1031 exchange, you’ll need to understand which property is which:
- The initial property that you own and want to sell is called the relinquished property.
- The property or properties you ultimately decide to buy is called the replacement property or properties.
This is not a program you should do on your own. In fact, you’ll need a trusted intermediary to be responsible for the funds as they transition from the relinquished property into the replacement property. Before it even gets to that point, make sure you’re working with a Santa Rosa property manager who has experience helping investors buy and sell through the 1031 exchange program.
Timing and Deadlines Santa Rosa Investors Need to Know
Let’s say you are ready to sell an investment property through a 1031 exchange and save yourself some money on taxes.
Here’s how the timing needs to work:
- First, you’ll need to sell your existing rental home, making it a relinquished property. Once the sale closes on that deal, the escrow company is going to move the proceeds from that sale into a qualified intermediary’s exchange account.
- Your intermediary holds the profits you earned from the sale of the relinquished property while you identify and purchase a replacement property.
- You have 45 days from the sale of your relinquished property to identify the replacement property.
- You have180 days to close on the replacement property. That’s 180 days total, from the closing date on the relinquished property sale. The calendar does not re-set after the 45 days you may use to identify a property.
Seems easy enough, right?
Those 180 days will actually go pretty fast. With the market somewhat less predictable now than it has been over the last year, you may need to put in some work to sell your property and then find a new one. We recommend you work as quickly as possible to complete this exchange. The longer you wait, the more time you have for complications to arise.
Finding a Santa Rosa Investment Property That’s Worth More
Another requirement that needs your attention is that you must buy a property that’s of equal or greater value to your relinquished property. So, if you sold a duplex for $1 million, you are required to buy another rental property for at least $1 million. Or, you can buy several properties as long as they equal $1 million or more.
When we’re talking about value, remember that you must also exchange one income-producing property for another income-producing property. You cannot use the 1031 exchange to sell a rental home and then buy a piece of land that isn’t attached to income. You cannot sell your rental home and then use the 1031 exchange to buy yourself a vacation home.
It’s critical to make an exchange – changing from one rental property to another rental property.
How to Succeed with a 1031 Exchange
Many investors and real estate professionals are big fans of the 1031 exchange. It’s a straightforward and effective investment tool to avoid paying taxes and helps you save some serious money when you want to sell a rental property.
But, it’s not perfect.
This tax benefit comes with a price, and you need to be prepared to deal with the potential challenges involved with a transaction like this.
First, there’s the pressure of deadlines. While it might seem like 45 days is plenty of time to find a replacement property that’s worth at least as much as the property you sold, it might not be as easy as you think. Markets change all the time, and if you’re in a market where there’s very little inventory or a lot of competition from other buyers, you might have a hard time locating a good replacement property. That 45-day window can feel like a lot of pressure.
This pressure could lead you to invest in a property that you wouldn’t otherwise buy. This is more likely to happen if you wait to begin your search for a replacement property. Be careful of the tendency to wait and find a replacement property later in the process or to grasp at any home that’s in your price range and available.
It’s still important to do your homework before you buy. It’s also important that you don’t wait too long when you do find a property that’s suitable for the exchange. You don’t want to find yourself in a situation where you find a great replacement property but then decide to think about it for a while. Maybe you’ll continue to look around and someone else will buy the property you had initially considered. Don’t wait too long to make a move.
What if you miss the deadline or find yourself with a failed 1031 exchange?
The exchange is canceled, and you have to pay taxes. You cannot touch even a dollar of the proceeds from your relinquished property. That money stays in escrow and you never see it. If you do use that money, you are out of the exchange and forced to pay your capital gains taxes.
Remember that you’re not canceling your taxes with this program. You’re simply deferring them. That’s a big difference from not paying taxes at all. There’s no limit to how often you can conduct a 1031 exchange. But, after 10 or 15 years, you may have deferred gains on hundreds of thousands of dollars. Maybe even a million dollars or more in profit. When you’re finally ready to unwind that final property and access the cash, your tax liability will be pretty huge. You have all of that gain over all those exchanges. You’re permanently locked in.
So, you need to understand your long-term strategy. By using a 1031 exchange, you might not be able to completely liquidate your portfolio in 10 or 15 years.
We love the idea of a 1031 exchange, and we encourage investors we work with to use this tax tool as an effective way to defer capital gains and avoid depreciation recapture. Just make sure you are prepared for the pressure of finding a replacement property quickly. You need to understand the risk of making bad decisions under that pressure and the long-term impact on your portfolio.
We offer you a couple of tips to make the process of a 1031 exchange less stressful:
- Start the process of looking for a replacement property as soon as possible. Identify a suitable replacement right away.
- Consult with a tax attorney. An expert can help you navigate the exchange process and protect you from mistakes.
- Work closely with a Santa Rosa property manager who can help you navigate the process and identify potential investment properties.
Let’s talk about how the 1031 exchange might work for your Santa Rosa investment goals. Please contact us at Prestige Real Estate & Property Management. We manage homes in Sonoma County, including Santa Rosa, Windsor, Sebastopol, Petaluma, and Rohnert Park.
