Investment properties are almost a two-in-one return opportunity. Not only can you regularly generate rental income, but the property will often increase in value over time and bring you even more returns in the end. But like most things in life, this opportunity can be a double-edged sword when it comes time to sell. Not only will you have to pay capital gains taxes on this increased value, but if you used depreciation to reduce your tax payments while you owned the property, the IRS would also recoup some of that depreciation.

The dual impact of capital gains taxes and recapture of depreciation can create hurdles if you are selling the property to purchase another investment property. The money you have to pay in taxes is money you can’t use to buy a new property, which lowers your investment budget. But sometimes there is a way around this, and it’s called a 1031 exchange.

The basic concept is that if you sell an investment property to use the money to buy another investment property, you can transfer your capital gains into the new property and not pay them when you sell the old one. But there are several factors that you will need to get right when performing a 1031 exchange; getting it wrong could result in the loss of this tax benefit.

Make sure it is a like exchange

The exchanged good must be of the “same kind” to be eligible. This means that you must exchange one investment property for another investment property. For example, you cannot trade an apartment complex for a house that you use as your residence. But you can trade in a single-family rental home for a duplex or an apartment building.

Use a qualified intermediary

Another critical factor is that while it doesn’t have to be a direct exchange without exchanging money, it must be what you might call a virtual exchange. When you sell your old investment property, the money from the sale cannot come directly to you. Instead, it must go to a Qualified Intermediary, who will hold the funds until they are used to purchase the new property.

This is where many people travel; they sell a property, take the money and then want to do a 1031 exchange on a new property. But because the money from the sale went into their account, they are no longer eligible.

Remember the deadlines

Timing is also essential. You have 45 days from the sale of an investment property to locate up to three potential replacement properties and send the list to the IRS. You then have an additional 135 days (for a total of 180 days) to choose your final selection and close on the new property, or in other words, you must complete the exchange within six months of the sale of the property. ‘origin.

Know all your options

There is a 1031 exchange option that removes some of these restrictions. Say your new property is in a government-designated Qualified Opportunity Zone, or QOZ. In this case, you may be eligible for the exchange even if you directly received the proceeds from the sale of your previous property. And if you keep the property for 10 years, you won’t owe taxes on any capital gains in QOZ property.

QOZs have significant tax advantages, but the increased risk may offset them. Properties in a QOZ are almost by definition low value. The government hopes your investment will increase property value to revitalize the area, but that doesn’t always happen. You therefore have a higher risk of low to negative returns on your investment than you do through more traditional 1031 exchanges.

Understand the pros and cons of a trust

What if you want to sell your investment property because you want to get out of the investment property game? One option is to set up a trust and sell the property to it. The trust can then pay you for the property over time in installments while investing the rest and paying you interest. Since the property will be a trust rather than an actual purchaser, capital gains taxes are deferred. After the term of the trust ends, the trust returns the capital to you, in which case you recognize and pay the capital gains.

This strategy gives you the flexibility to time the timing of capital gains recognition and earn interest on a much larger remittance note than the value would have been had you recognized the tax on the sale of the property today. today.

There is a downside to this plan if you have heirs. Ownership is a powerful asset to pass on to beneficiaries, as capital gains and recapture of depreciation disappear once ownership is transferred on death. This clearly cannot happen if you have technically sold the property to a trust.

Work with a financial planner

There’s a lot to unpack here and many nuances you need to fully understand to prepare for the best tax situation when selling an investment property. If this is an investment strategy that interests you, working with a financial planner on investment property trading and sales is essential.

Defined Financial Planning, LLC (“DFP”) is a registered investment adviser providing advisory services in the state(s) of California, Nevada and other exempt jurisdictions. The following content is provided by DFP and is subject to change at any time without notice. The content provided here is for informational purposes only and should not be used or construed as investment, tax, legal advice or a recommendation regarding your specific financial situation. Past performance may not be indicative of future results. All references to future rates of return are for illustrative purposes only and are not guarantees of future performance. Any investment involves risk, including the possibility of loss of capital. There can be no assurance that any investment plan or strategy will be successful.

Senior Manager, Financial Planning Manager, Defined Financial Planning

As Director and Director of Financial Planning, Sam Gaeta helps clients identify financial goals and make plan recommendations using the five areas of financial planning: cash flow, investments, insurance, taxes and estate planning. . He is responsible for prioritizing clients’ financial goals and effectively implementing their investment plans and actively monitors the ever-changing nature of clients’ financial and investment plans.

The appearances in Kiplinger were obtained through a public relations program. The columnist received help from a public relations firm to prepare this article for submission to Kiplinger.com. Kiplinger was not compensated in any way.