Many rental property owners start by purchasing an inexpensive house as a rental property investment. Although this makes the investment affordable, it limits rental income, and often attracts less than ideal tenants. As principal and appreciation build over time, it can make sense for the investor to trade up to a more valuable rental property. Many investors hesitate because of potential tax consequences. However, a “rollover purchase” can be done TAX FREE with a 1031 Exchange. An investor can rollover financial gains into a new rental property investment without having to worry about capital gains taxes.
For example, say you purchased an investment property for $100,000 a few years ago with a 20% down payment. Let’s say your principal is now $25,000, and the property has gained $20,000 in value. Without a 1031 Exchange, you would pay capital gains tax of 15% – 20% depending on your income. You would lose $3,000 – $4,000 to the tax man if you sold the property and bought a newer one. Yet by using a 1031 Exchange, you can defer the capital gains tax by reinvesting in a higher priced rental property investment with more revenue potential.
A 1031 Exchange has strict rules that must be followed. First, the property you are selling must have been used in a trade, or business, or for investment. (Fix and flip properties would not likely qualify.) You’ll need to hire an Exchange Facilitator licensed to manage these types of transactions. Then, you’ll have 45 days from the time your original investment is sold to identify possible replacement properties, and 180 days to complete the replacement purchase. There are many other restrictions that your Exchange Facilitator will explain.
If you are pondering the possibility of upgrading the type of investment property you own, take a closer look at a 1031 Exchange. It can make a big difference in the price and quality of investment you can afford.