1031 Exchange : Sell Property Without The Tax Hit

September 12, 2016 - 3 min read

What Is A 1031 Exchange?

A 1031 exchange is the process of selling an asset and buying another similar asset, thereby deferring capital gains tax.

If you sell an investment property — or a vacation home that you also rent out — you can reinvest the proceeds on which you would normally pay taxes, by taking advantage of section 1031 of the Internal Revenue Code.

How does a 1031 exchange work? You purchase a qualified “like-kind” replacement property within 180 days. The IRS disregards the profit on the sale, since it is re-invested in another asset. You can defer paying capital gains and depreciation recapture taxes normally triggered by the sale.

The exchange must be conducted to the letter, but if you do it correctly, your tax savings could reach five or even six figures.

Why is a 1031 exchange smart now? Investment property mortgage rates are low. You could retire your existing loan, and get a loan on a new property at a much lower rate.

Plus, property values have increased 36% since 2012. If you can delay paying capital gains tax on the profit, you probably should.

If you are thinking of selling an investment property and buying another, consider a 1031 exchange before listing the home for sale.

1031 Exchange Mortgage Considerations

Your new property’s mortgage is part of the equation.

The 1031 Exchange is called a “like-kind” exchange for a reason. Any part of the new purchase that is not like the old sale can cost you.

For example, you sell a rental home for $300,000 with a $200,000 mortgage. Don’t buy a $100,000 rental cabin with the net proceeds. This is not a “like kind” exchange.

Rather, your replacement property must cost at least $300,000, and its mortgage must be at least $200,000. Otherwise, you could be hit with the taxes you’re trying to avoid.

Be Careful How You Pay For Closing Costs

The IRS sets special rules when you use use proceeds from the sale of the old property to pay closing costs on the new one.

The costs must be “normal transactional costs.” These mortgage closing costs are not considered normal costs for tax purposes:

  • Lender charges
  • Lender’s title insurance
  • Points
  • Mortgage insurance (upfront premium)

You’ll need to pay these costs from other funds, have the seller cover them, or choose to have the lender cover them via a no-closing-cost mortgage.

Who Is On The Property’s Title?

Residential mortgage lenders typically do not make loans to living trusts, revocable trusts, LLCs or partnerships.

The property title and the loan will need to be in your name, however the title can be changed later with no tax consequences to you.

Make sure that transferring the title back to your business entity or trust won’t trigger a due-on-sale clause with your lender.

Property Status Is Important

Some buyers try to pass off an investment property as their primary residence.

That’s a bad idea for a lot of reasons, but especially in the case of a 1031 exchange.

Underwriters know these transactions are for investment property only, and your lender will not fund the loan if you misrepresent the property use.

Trying to pass off a 1031 property as a primary residence is a rookie mistake by which more seasoned investors aren’t even tempted.

Set a Timeline For Your Sale And Purchase

The IRS imposes very strict target dates and accepts no excuses.

Mortgage problems can cause you to miss your 180-day deadline for closing on the new home. In that case, your tax savings would evaporate. Minimize the odds of missing the window.

  • Get pre-approved for your mortgage before selling the existing property
  • Keep your loan file updated with recent income and asset documents
  • Use a reputable Qualified Intermediary for your 1031 exchange
  • Respond to all requests from your lender and your intermediary
  • Don’t apply for new credit

A 1031 exchange allows smart real estate investors to defer taxes and create more cash flow. However, check with a tax adviser before filing, as there are caveats and exceptions to any portion of the tax code. Only an expert is qualified to give tax advice.

As for the mortgage, plan ahead. You can achieve your investment goals with the right lending products. Your lender should be on your team at the outset when planning a 1031 exchange.

What Are Today’s Rates?

Investment property mortgage rates are low. This is a rare opportunity to finance your new real estate at rock-bottom costs, and turn significant cash flow.

Get a quote now. Quote don’t require a social security number to start, and there’s no obligation to continue if you are not satisfied with your rate.

Gina Freeman
Authored By: Gina Freeman

The Mortgage Reports contributor

With more than 10 years in the mortgage industry, and another 10 years writing about it, Gina Freeman brings a wealth of knowledge to The Mortgage Reports as its Associate Editor. Gina works with a team of world-class real estate and finance writers to bring timely and helpful news and advice to the audience. Her specialty is helping consumers understand complex and intimidating topics.