1031 Exchange
You don’t want to pay taxes on the sale of your home or income property? Here is some information on 1031 Exchanges and other tax deferral programs:
Real estate investments come with a lot of great benefits. Some of these benefits are tax advantages. As the owner of investment property, you can deduct many of the expenses associated with your property, including maintenance, mortgage interest, insurance, property management fees, and you can use depreciation to lower your overall tax liability.
While the benefits can be great, there can also be tax liabilities when you sell a real estate asset.
As you may already know, when you buy a property and hold onto it for a period of time, you’ve earned profits from it and taken depreciation credits, there can be tax consequences when you decide to sell the property. You’ll have to pay capital gains taxes on the profits you earned on the investment; and, you’ll have depreciation recapture to manage. Those taxes can cut into your ROI and can be a substantial drain on your motivation to sell.
A 1031 Exchange is an option for real estate investors like you. Most investors find that it’s a valuable tool for protecting their profit from capital gains and other taxes.
What is a 1031 Exchange Program?
The 1031 Exchange is named for the IRS tax code to which it pertains. It’s also known as a Starker Exchange, named after an investor who won a case against the US government that allowed them to use the tax deferred exchange. According to this rule, an investor who has made a profit from a real estate investment or taken depreciation tax credits can defer the tax on both if:
- They purchase another property or properties of equal or greater value
- It must be a like-kind property
- Everything must be completed during the specified exchange period in a 1031 Exchange
1031 Exchange is an incredibly useful tool for many real estate investors, especially when trying to leverage their investment properties. If you find yourself wanting to sell but resisting the urge because you don’t want to incur those tax burdens, this program might be exactly what you need. It allows you to unlock the equity and profits you have in your current property and move that profit into other properties with more growth potential or diverse investment benefits.
Common 1031 Exchange Terminology
Some terms you need to understand are:
- The property you want to sell is called the “Relinquished Property”
- The property you want to buy is called the “Replacement Property”
You’ll want to understand the process and its rules completely before you venture into this process. We also recommend working with a licensed “Exchange Company.” We will be more than happy to refer you to the companies we currently work with.
Deadlines and Restrictions Associated with 1031 Exchanges
Let’s say you have a rental property that you want to sell. You don’t want to recapture the depreciation you claimed on your taxes, and you don’t want to pay capital gains taxes. So, you decide you’re going to sell the property through a 1031 exchange and save yourself some money.
First, you’ll probably sell your rental home, making it a relinquished property. Once the sale closes on that deal, the escrow company will move the proceeds from that sale into a qualified intermediary’s exchange account.
You need a qualified intermediary (or “exchange company”) to complete the 1031 property exchange.
The exchange facilitator holds the profits you earned from selling the old property.
1031 Exchange Time Requirements
Now, you have 45 days from your original property’s closing date to identify a replacement property.
You are also required to close on the replacement property within 180 days of closing on the relinquished property sale.
This timeline might seem relatively easy to follow. With 45 days to identify a property and 180 days to close on that property, you probably feel like you have plenty of breathing room. As always in real estate, time is of the essence. The longer you wait, or take, the less time you have to deal with any unforeseen issues or hurdles that commonly appear in any given real estate transaction.
1031 Exchange Property Requirements
The other restriction is that you’re required to buy a property of equal or greater value. So, if you sold a duplex for $500,000, you are required to buy another rental property for at least $500,000. You may also purchase multiple properties, that cumulatively add up to $500,000 or more.
It is also necessary to exchange one investment property for another investment property. You need to make sure you’re making an exchange for “like kind property”. Single-family rental homes, condos, commercial property, farmland, bare land, and any other interest in real estate that is held for business or investment, and is in the United States, is like-kind and can be exchanged. You can also buy and sell multiple properties within one exchange.
Another important point is that you cannot take possession or spend any of the proceeds from your relinquished property. By doing so, you will be taxed on the amount. The funds from your sale must go from escrow- directly to your qualified intermediary, or qualified exchange company’s account.
The Challenges of a 1031 Exchange
Many investors and real estate professionals are big fans of the 1031 exchange. It’s a straightforward and effective investment tool to save serious money. It’s not perfect and you do need to be prepared to deal with the potential downside of a transaction like:
Con: 45-Day Timeline
First, there’s the pressure of deadlines. While it might seem like 45 days is plenty of time to find a replacement property, it might not be as easy as you think. Markets change all the time, and if you’re in a market where there’s very little inventory or a lot of competition from other buyers, you might have a hard time locating a suitable replacement property. In a seller’s market, it’s possible that 45 days may not be enough time to find a replacement property. There is another alternative and that’s exchanging into a DST (Delaware statutory trust). Contact me for more details about this option.
Con: Pressure to Find a Property
What does this mean for you? It means that if you’re feeling pressured to find the right property, you might buy something that you wouldn’t otherwise buy. You might settle for a property that isn’t quite right for your investment goals. It’s important to do your homework before you buy. It’s also important that you don’t wait too long to find a suitable property for the exchange. I’ve seen investors who find a great replacement property, but they decide to think about it for a while or continue looking around. They end up not putting the property in contract and, ultimately, risk losing the property because they waited too long to make a move. This is especially relevant in a seller’s market.
Con: Potential Tax Implications
If you have a failed exchange, you must pay taxes. Make sure you’re prepared to find and buy a replacement property as soon as possible. It’s best to be looking for a replacement property when your property is placed for sale.
There’s another potential issue, and it’s an issue of investors doing multiple 1031 exchange transactions. You may have purchased a property and earned a profit so you sold it and leveraged it into multiple properties. Then, in a few years, you do it again or you do it three or four more times. After several years, you have deferred gains on hundreds of thousands of profits. Maybe even millions of dollars in profit. When you’re finally ready to access the cash, your tax liability could be huge. You have all the capital gain over all those transactions. You’re almost permanently locked in. Almost…..
How Your Heirs Can Inherit Your Property Without Paying Your Deferred Taxes
You might be locked into paying deferred depreciation recapture and capital gains tax, but your heirs don’t have to be. If you die before ending your run of 1031 exchanges, your heirs receive your real estate investment on a stepped-up basis, which means that they get the asset at its fair market value at the time of the owner’s death.
Imagine if you began your investment career with a $300,000 property, and via a series of 1031 exchanges, finished off with properties worth $10,000,000. Instead of paying capital gains on almost $10,000,000, your heirs won’t have to pay capital gains tax at all. They may have to pay estate taxes and should consult with a tax and financial advisor. But the taxes will be far less than all the deferred taxes they would have had to pay otherwise!
How a Section 121 Can Save You Hundreds of Thousands of Dollars
Thanks to Section 121 of the Internal Revenue Code, the taxpayer is entitled to a $250,000 (if single) or $500,000 (if married filing jointly) exclusion on the sale of any property they own and have used as a primary residence (AKA “principal residence”) for 24 out of the last 60 months. With an exclusion, it isn’t necessary to pay taxes or reinvest the proceeds. These 24 months also don’t have to be spent consecutively.
Like a 1031 Exchange, I’d advise you to consult with your tax advisor directly before performing a section 121 Exclusion to make sure it’s done correctly.
Straight Forward 1031 Exchange and Section 121 Exclusion
There are several ways in which the 1031 Exchange and a Section 121 Exclusion can complement one another. Here’s a straightforward example:
- You buy a property and live in it for two years. Then you move out and convert that property into a rental.
- You keep the property as an investment for 18 months.
- You sell the rental property and get to use the Section 121 Exclusion and the tax deferrals from the 1031 Exchange.
121 Exclusion and 1031 Exchange with Allocation
You can also combine a 121 Exclusion with a 1031 Exchange when a portion of your business property is your primary residence.
You own a multi-unit rental property. It has four units. You live in one and rent out the other three. You can still use the 121 Exclusion and 1031 Exchange just like in the straightforward example, except you would need to “allocate” the part used as a principal residence when performing the 1031 Exchange.
When you perform your 1031 Exchange, you’ll allocate the principal residence part and employ the Section 121 Exclusion toward the exchange proceeds from that part rather than the whole complex, which means that only the profit from the principal residence portion will be eligible for the Section 121 Exclusion. The three remaining units’ profit would go toward the 1031 Exchange’s new property.
Using a 121 Exclusion After a 1031 Exchange
If you convert your replacement property into a principal residence, you can use a Section 121 Exclusion to eliminate some or all the gain. To do so, you must own the replacement property for at least five years after the Exchange is performed. This is the case even though the property must be a principal residence for only two years to meet the Section 121 requirement. Once those two criteria are met, the property may be sold, and the Section 121 Exclusion may be applied.
When applying a Section 121 Exclusion after an Exchange has been performed, the relationship between the number of years the property is used as an investment property relative to how long it’s owned overall will determine how much of the gain may be excluded.
Simply put, you make a fraction where the total number of years that the property was an investment property (non-qualifying use) is the numerator, and the total number of years the property has been owned is the denominator. Suppose the property was owned for five years after the transaction and was a principal residence for four years. In that case, the numerator is the number of years the property had non-qualifying use (1), and the denominator is the number of years it was owned overall (5). That means ½ of the gain would be considered non-excludable.
The holding requirements on the post-sale side of the 1031 Exchange transaction are do or die. Professional tax consultation is advised so you don’t end up missing your opportunity for massive savings by converting your investment property into a principal residence too early.
Bottom Line on 1031 Tax Exchanges
You need to understand your long-term strategy. Using a 1031 Exchange, you might not be able to completely liquidate your portfolio after several years. I love the idea of a 1031 exchange. I encourage every real estate investor I work with to use this tax tool as an effective way to defer capital gains and avoid depreciation recapture and most importantly build wealth.
Just make sure you are prepared for the pressure of finding a potential replacement property quickly. You need to understand the risk of making bad decisions under pressure and the long-term impact on your portfolio.
Quick Tips to Remember When Considering a 1031 Exchange
- Start the process of looking for a replacement property as soon as possible.
- Identify a suitable replacement right away.
- Consult with a tax advisor.
- I can help you navigate the exchange process and help you avoid mistakes.
I have experience and many years doing 1031 Exchange transactions.
Let me assist you in building your real estate wealth
