One complication that comes with owning multifamily property is the capital gains and other tax consequences of your investment. While it's the goal of every real estate investor to eventually upgrade to more valuable properties eventually, conventional property sales carry a high enough tax burden that it often isn't worth doing, especially for properties only a little more valuable than what you have now. You can defer this tax with a special kind of real estate transaction, called a 1031 exchange, that might bring those marginally more valuable multifamily properties within range and make a potentially complicated transaction simple enough to do for investors of any size.
What is a 1031 Exchange?
The 1031 exchange is a special kind of real estate transaction that can let you defer the normal costs of property sales and acquisition. Named for section 1031 of the tax code, these exchanges permit you to skip paying the capital gains tax on a property you're selling, if you buy another investment property within 180 days. You can also roll forward your depreciation, which can be an enormous help if your multifamily property winds up selling for more than you paid for it.
Who Can Use a 1031 Exchange?
Any real estate investor can take advantage of section 1031. If you own a multifamily property in Arizona, 1031 exchanges can help you climb the property ladder without incurring prohibitive taxes every time you transfer ownership. While the specifics get complicated, even by the standards of the tax code, you can generally use a 1031 to sell and buy properties you're holding for an investment. This includes multifamily apartment complexes, duplexes, single-family houses, commercial buildings and even empty lots, though you're generally expected to hold your acquisitions for at least two years before selling again. The 1031 deferment is not for private residences you plan to live in, nor is it for a commercial or industrial site you're working at, as opposed to owning for the property value or rent itself. You also cannot use a 1031 to exchange real estate for anything other than other properties, which must be "of like kind," as opposed to selling your multifamily property and buying gold or savings bonds with the proceeds.
How Does the 1031 Process Work?
To get the full advantage from a 1031 exchange, it is extremely important to go through the steps the IRS has laid out. Getting professional help with the process is a very good idea, since this is usually a major transaction and taxes owed from a mistake along the way can wipe out the profit you make from selling your property.
Federal law requires 1031 sales to go through a qualified intermediary. Find the most experienced brokerage you can for this, since the timing of the sales and payment are very important.
List your multifamily property as you normally would but be sure to mention that you are looking to do a 1031 exchange. Notify any interested buyers of your arrangements in writing as early as you can.
Negotiate the sale price as you normally would. This part of the exchange is not significantly different from any other investment property sale, except that the buyer pays the intermediary, not your company.
Once the sale closes, you have 45 days to give the intermediary three new property listings you're looking into. Make sure the sellers of these properties know you're doing a 1031, and that time is short to close.
Sign the contract with your first-choice property. You can sign contracts on all three to be safe, but make sure you have contingency clauses to back out if your preferred deal closes first.
Once you've agreed to a deal with the seller(s) of your new property, you have up to 180 days to close escrow and wrap up the deal. Keep your deadlines in mind, since the IRS can both charge you capital gains tax and recover the depreciation you've been writing off if the deal takes too long.
Trading properties through a 1031 exchange takes patience and attention to detail. It also takes an aggressive REALTOR® that knows the Phoenix market well and has experience representing owners of multifamily properties in Arizona. Patrick O’Sullivan with Cap CORE Real Estate can help you manage the property transfer when completing a 1031 exchange on your multifamily property. Call us today at (602) 366-5078 to speak to a Patrick today.