How 1031 Exchanges Can Make Property Investment More Tax Efficient

It's the busiest time of the year in real estate and that doesn't just mean that a lot of homes are changing hands.

This is also a popular time of year for investors to decide to cash out of at least part of a property portfolio, or perhaps the intention is to sell and find a property that's capable of yielding stronger returns.

Taxation is always an important consideration in these matters and clearly the first thing you should do is talk to your consultant about what's best for you. Good professional advice is absolutely paramount.

I'm not trying to intervene in that process at all, but I would nonetheless like to point you in the general direction of a very useful tax code that, in the right circumstances, could potentially save you a lot of money.

I'm talking about the 1031 Exchange.

In essence, this is a tax code that enables an investor to upgrade a rental property, or in some cases swapping, say, an apartment building for land or some other kind of business premises, but pay no tax, or a limited amount, at the time of exchange.

Although the loopholes were tightened a few years ago, it's sometimes even possible to do a 1031 when swapping vacation homes (again, talk to your advisor). It's important to stress, however, that the code is not applicable for personal use.

1031 Exchanges ideally occur when there is a "like-kind" simultaneous swap of property between two parties. In practice, of course, it's often the case that such a perfect set of circumstances doesn't happen.

It's therefore possible to arrange what is known as a delayed exchange, whereby an intermediary holds the proceeds from your property sale until you use it to buy the sort of property you are looking for.

Do bear in mind that there are some strict time limits that have to be observed. The replacement property you wish to acquire must be declared in writing to the intermediary within 45 days of the sale of your previous property. And although strict number and valuation regulations apply, it's often possible to designate multiple properties as the replacement.

No matter how it all works out, you have to close the sale of the newly purchased property within 180 days of the sale of the old one. That doesn't mean, though, that you can take, say, 30 days to declare the replacement property and tack on another 180 days. In that example, you have just 150 days left to complete, if you are to retain any 1031 entitlements.

I again stress the need to talk to an expert, because there can still be immediate tax liabilities if, let's say, you gain money by borrowing less on the new property than the old one.

I hope that this brief general guidance at least alerts you to the exciting options that the 1031 Exchange may open up for you. I can, of course, connect you with experts in this field, so please don't hesitate to contact me on this or any other aspect of real estate.

Dominic Nicoli