What Is A 1031 Tax Exchange

Keys in the shape of 1031 to depict a 1031 tax exchange

A 1031 allows you to avoid paying capital gains when you sell an investment property and reinvest the proceeds from the sale into another property or properties of equal to or greater than value, within certain time limits. The 1031 Tax Exchange allows you to defer the tax on the appreciation to a later date. If you were to simply sell your current investment property and buy another updated, upgraded, more expensive property, next year come tax time you will owe capital gains. This could be as much as 20% on the appreciation and profits on the property since you owned it. Please note this explanation is from a real estate agent.  I am not a CPA or an accountant.  This explanation is an example and highlights what could happen.  If you instead do a 1031 tax exchange when you sell the property you will not owe capital gains taxes.

How does a 1031 tax exchange work? 

What is the process?  If you were to participate in a 1031 tax exchange the process would be as follows. You list the property that you currently own for sale.  We will call that property your relinquished property.  You accept a contract to purchase and go through the process to sell your relinquished property just like you would if you were not doing a 1031.  Here is what is different and keeps you from paying taxes.  Once the relinquished property is listed for sale you contact an exchange company.  Ask you real estate agent for recommendations. The exchange prepares documents that must be signed, prior to and at the closing. The exchange company charges a fee for their services. 

How Does Closing Work?

The closing occurs and the exchange company takes the proceeds from the relinquished property closing and holds the proceeds from that sale until the closing on the replacement property that you are in purchasing.  After the closing on the relinquished property you will attend the closing of your more expensive property.  You attend the closing with your ID and a smile on your face.  In advance of the closing, the exchange company wired the funds from the sale of your relinquished property to the title company.  You sign the documents for the closing and you are handed the keys.  You have just participated in a 1031 tax exchange. This is a simplistic description of the process.  Moreover, there are very specific rules that must be followed for a 1031 exchange to be successful.  Timing is very important.

If you are interested in learning more about a 1031 and how you might benefit from participating in one you should consult a CPA that can walk you through the details.  If you decide to do a 1031 tax exchange contact us to make sure you work with a real estate agent that is familiar with 1031 so that you can successfully complete an exchange.

Capital Gains When Selling A House

Capital gains when selling occurs when you sell real estate for more than you paid for it. The difference between the original sales purchase price paid and the new sales price is the gain. In other words:

New sales price, minus purchase price of the property, minus the cost of sale = the amount of gain on the property.

This calculation can mean that most all sellers that are selling their home in Northern Colorado would show a gain on their property. Our market has seen nice appreciation of property values in recent years and this can lead to nice gain when it comes time to sell. It is great to sell your home for top dollar, but the IRS may want a piece of the gain that you receive.

What situations do you have to pay capital gains when selling?

The government allows you to exclude $250,000 in gain for an individual home seller and exclude $500,000 in gain for a married couple. For example, lets say that you bought a property 10 years ago for $250,000 and sold the property for $850,000. You are a married couple, filling your taxes jointly, selling your home that you have lived in the home for all of the last 10 years. First, you subtract the $250,000 from the $850,00 and the number is $600,000. You are allowed by the IRS to have $500,000 in gain so you will only pay taxes on the $100,000 which is over the $500,000. How bad might the taxes on that $100,000 in gain be. There are factors that the IRS takes into account when figuring but for a rough estimate the tax could be between 10 and 20 %.

In order to be able to exclude the gain, like in the example above you need to have:

  1. Lived in the home for at least 2 of the last 5 years.
  2. The home needs to have been your primary residence.
  3. You can not have claimed that you sold a primary residence in the last two year period.
  4. If you are selling your home in less than two years, but moving due to work, health or an unforeseeable event, you still might qualify!
  5. You also may be able to minimize your capital gains tax if you are able to show receipts for home improvements.
    If this sounds complicated it really might be. This might be the year to have a CPA do your taxes. The money spent to have a professional review your tax situation might be small in comparison to the amount you save in taxes paid.

Contact us if you have specific questions about capital gains when selling a house.