Investors, take note: profound changes could be coming as to how capital gains taxes are assessed and collected. This fall, a ranking member of the Senate Finance Committee introduced a proposal that would completely overhaul the capital gains tax system. Experts think it has a good chance of passing if a Democratic administration takes office next year.
The proposal would assess capital gains taxes each year, based on the amount of asset appreciation in the past year. This will happen instead of taxing all the accumulated capital gains when you sell.
Let’s look at a quick example of how this would work. Under the present system, if you buy a house worth $1 million that then gains $100,000 in value every year, you’ll only pay capital gains when you sell.
If you sell after five years, you’ll be liable for capital gains on $500,000 of increased value, which you can pay or, preferably, defer (which we’ll cover below).
The new system would assess capital gains every year, so you’d have to pay capital gains on $100,000 of increased value each year. Obviously, this would make it much more expensive, and much more difficult, to hold onto your investments.
While it’s no sure thing that this system will be put in place, it’s a safe bet, considering Trump’s reluctance to cut capital gains taxes. The tax climate isn’t going to get any better for investors.
Luckily, the best way to handle capital gains taxes under the present system is also the best way to defer them before a new system disrupts your entire investment strategy. Consider the mighty 1031 exchange.
What is the 1031 Exchange?
A 1031 exchange is a provision in the tax code that allows you to essentially trade one investment property for another without paying capital gains taxes.
It works like this: you sell your investment property, and through a third party intermediary and within a certain time window, flip the full proceeds from that sale into the purchase of a subsequent property or properties while deferring your capital gains tax liability.
So instead of giving 40% of your profit to the IRS, you can put it down on your next investment. Done properly, this allows you to supercharge your investment timeline.
Of course, it’s not quite as simple as that. Like most tax maneuvers, there are a lot of conditions and deadlines that have to be met. Let’s go over some of the basics.
You must be upgrading properties
The 1031 exchange is for established investors looking to scale up. You can’t simply sell off an investment property and use 1031 to protect your profits; you must be using the proceeds from your initial sale to buy a subsequent property of equal or greater value.
To put it simply, the 1031 exchange is a tool for beginning or intermediate investors to quickly build up their investment portfolio without being dragged down by capital gains taxes.
In one of the most common scenarios, the investor sells the initial property and uses the proceeds as a 20% down payment on their next investment. In this way, a $2 million investment can be flipped into a $10 million one.
You can’t use 1031 on the sale of your primary residence
Sorry, but homeowners can’t use the 1031 exchange to defer taxes on the sale of their primary residence.
Of course, the present tax code provides a generous capital gains exemption for when you sell your home.
The property you’re buying must be similar to the one you’re selling
The properties involved don’t have to be identical, but they have to be similar. For example, if you’re selling a single-family rental, you can buy a more expensive single-family rental or even a multi-family building, but you can’t flip a single-family rental into, say, a strip mall or an office building.
You have to move fast
When you use a 1031 exchange, you’re agreeing to a long list of time limits and requirements.
Once you sell your initial property, you have 45 days to identify your next investment. Six weeks isn’t a long time to settle on what will likely be a six or seven-figure purchase, so you’ll want to start eyeing potential buys well before you sell your initial property.
Since none of this is taking place in a vacuum, and other buyers could step in to outbid you, 1031 does grant a little breathing room to investors. Investors can actually identify up to three replacement properties; they don’t have to buy all three properties on this list, but they do have to buy at least one.
If they buy more than one, the total value must be equal or greater than the sale price of the initial property. This makes it much easier to complete the exchange within the time window, though keep in mind that if you choose to buy two or even three replacement properties, that’s also two or three times more things that could potentially go wrong.
You must complete the purchase of your replacement property within 180 days of selling the initial property. If there are delays or snags, and it takes extra time, you could lose all the tax deferral benefits of the 1031 exchange.
The future of the 1031 Exchange
If the tax overhaul discussed above is passed into law, it’s unclear what effects it would have on the 1031 exchange. Either the rules of the exchange would have to be rewritten along with the capital gains laws.
However, it’s likely that any 1031 tax deferrals that happened before the overhaul would be grandfathered in, so if you’re still building up your investment portfolio, it might make sense to keep one eye on the headlines. A 1031 exchange only takes 180 days to complete but could save you years or decades of tax pain.
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