When it comes to long-term investment, it’s hard to beat the stability and return of real estate. There’s just one problem, and that’s capital gains taxes. This is the tax you pay on the money you make from selling an investment property. Capital gains taxes can disrupt plans for purchasing a more lucrative property or just trying something new. However, there is a way to defer these taxes called a 1031 exchange investment.
This is how the IRS explains the provision:
“Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free. (IRS, 2008, Para. 1).”
Let’s unpack what this means for a desert valley property investor. This kind of transaction, also called a like-kind exchange, applies only when you buy another investment property after selling the first. The property must be in the United States and must be for investment purposes, meaning it can’t be your residence. However, in some cases, a 1031 exchange can apply for a vacation property or for tenants in common real estate.
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There is also a strict time frame for a 1031 exchange investment. The second property must be designated within 45 days of selling the first one. Also, you must close on the property within six months, that is, 180 days.
Finally, keep in mind that this is a tax deferment, not a tax exemption. This means that if the purchase price of the second property is less than the selling price of the first, you will have to pay taxes on the difference, usually as a capital gains tax. When you sell the property for cash, taxes will be due. If you are considering a 1031 exchange, please speak to an accountant or attorney who specializes in this type of transaction.
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