Section 1031 Tax Deferred Exchange: avoiding capital gains since 1921

In continuation of last week’s post about the 121 exclusion, we’ll be covering the 1031 tax deferred exchange (pronounced ten-thirty-one exchange). If you haven’t read the previous blog post on how to avoid capital gains when selling your primary residence, check it out here Section 121 Exclusion. I consider the 1031 exchange the most powerful tool for generational wealth in today’s arsenal of available real estate tax strategies. It will help you save on taxes AND build significantly more wealth.

What is the 1031 Exchange?

When you sell real estate for net profit, you’ll probably pay some capital gains on it. If you’re a bad investor and incur no gains on sale, you will have no financial gain. Don’t fret, you’re a SMART real estate investor cause you’re reading this blog!

If you sell your investment, and assuming you held it for 2+ years,  you’ll end up paying capital gains (15% for most folks).

Example:
Billy buys a 5 unit apartment complex for $500,000 and sells it 2 years later for $700,000. His net profit would be $200,000 and he’d be on the hook for paying capital gains taxes on his $200,000. His payment to Uncle Sam would be in the realm of $24,000.

What if I told you you could defer payment of that tax to your next investment purchase? You can as long as it’s a like-kind exchange and you use the profits from the sale to purchase the new property. What if I told you you could defer all capital gains indefinitely AND permanently avoid paying ANY of it? Well let me explain to you the big picture first.

First off, the 1031 exchange actually applies to more than just real estate. You can actually tax defer on the sale of your cattle, your collectible car, your priceless paintings. But since this is a real estate blog, we’ll be focusing on real estate assets only.

The IRS essentially incentivizes you to hold on to your capital gains and create an IOU to the government in return that you’ll someday pay your share of taxes should you “break” your 1031 exchange cycle. Once you stop the cycle of exchanging properties, you will owe all capital gains taxes from every prior transaction (unless you die, but we’ll get to that later). That’s A LOT! As a smart real estate investor, you should never stop the exchange cycle unless it makes sense financially.

How does it work?

When you sell your property, all net proceeds from the sale are held by a QI (qualified intermediary). A QI is a third party company who keeps all the proceeds until you find a like-kind replacement property and releases the funds when you close on the new purchase. You won’t be realizing a dime of the proceeds as it’ll be fully invested into another property. Thus the saying for most real estate investors, “house rich, cash poor”.

One of the long-term advantages of the 1031 exchange is the ability to shift your portfolio of properties from high appreciation to high cash-flow properties without incurring penalties from sale like capital gains taxes. You’re able to rebalance your portfolio dependent on your needs. Are you young and want high risk, high maintenance, but high appreciation properties or are you older and want more stabilized, low maintenance, cash-flow type of properties? Or perhaps you want to move locations of your investments without the IRS knocking at your door.  With the 1031 exchange, you’re able to choose as you see fit.

Examples of 1031 exchange in action

1031 exchanges can be simple or very complex. here’s a couple examples of individuals who have used the 1031 exchange to defer capital gains on the sales of their real estate investments.

2 For 1 Deal

In this value add play, Billy buys a $2.2M 32-unit apartment in Ogden, UT. It was 60% vacant at the time of purchase due to mismanagement. So Billy comes in and evicts problem tenants, renovates every unit to get higher rents, and turns the whole operation around by placing in his own property manager. In the end, the property went from 60% to 90% occupied and sold for $4.5M. His net proceeds from this sale was approximately $2,000,000. Capital gains on the proceeds would have equated to $375,000 Billy would have to pay.

Instead, he did a 1031 exchange into TWO apartments. $1.0M as down-payment into a $3.4M 45-unit apartment and the other $1M as down payment into a $4.2M 62-unit apartment. Not only did BIlly avoid paying the capital gains taxes, he was also able to leverage all of his proceeds from the $4.5M sale to $7.6M worth of real estate.

121 Exclusion and 1031 exchange combo

Here’s another strategy in combination of the 121 Exclusion for younger folks or First Time Home Buyers.

Sarah purchases her first home for $350,000, lives in the home for 2 years and then rents it out for 3 years. While she rented out the home, she also bought another home for $450,000 and lives there. She has an option to sell the first home for $575,000 and use the 121 Exclusion to be exempt from paying any capital gains OR she could elect to continue renting out her first home and use the 1031 exchange later down the road. Keep in mind that you cannot move back into your original home after the “2 out of 5” years rule is up. You’ll have to pay a portion of capital gains when you sell the first home if that’s the case.

Example:

Sarah decides to keep renting out her first home for the next 7 years after which she sells the home for $700,000, netting $300,000 in net proceeds. Sarah elects to do a 1031 exchange to defer all her capital gains into her next investment. With her proceeds, she purchases a $900,000 triplex apartment which will net her $1,700/month after all expenses.

1031 Exchange Rules

Of course, with every good thing there are rules! Understand that there are VERY strict rules. If you do not follow them, you will not qualify for the exchange. Easy, right? Let’s dive into the requirements.

Property must be like-kind

As explained earlier, the exchange must be for a like-kind property meaning house => vacant land, condo => 4-unit apartment, apartment => self-storage facility. Note, you cannot exchange for a primary or secondary home and the property must in the United States.

You also cannot exchange into a short-term holding (House flippers, I’m looking at you).

The replacement property must be of equal or greater value

The IRS requires you to exchange for a property that is equal or greater in value of the original property. For example, if your relinquished property sells for $500,000, the newly purchased property needs to be $500,000 or more. You could also purchase multiple different properties – the catch is the total purchase price of all the homes combined must equal or be greater than $500,000.

It is possible to do a partial 1031 exchange where only a portion of the proceeds are utilized in the next purchase. Any capital gains withheld from the relinquished property will be taxed normally. If the relinquished property sold for $800,000 and you elected to only buy a $700,000 house, you would still owe the normal capital gains taxes on the $100,000 difference. The $100,000 called the cash “boot”.

45-day identification window

When you sell your relinquished property, you will have 45 days to identify your replacement property or up to 3 and no more than that! As an experienced investor, 45 days is NOT a lot of time. I don’t expect to find a slam dunk deal in 45 days so one strategy is to begin looking for a replacement property PRIOR to selling your relinquishing property because once you sell the relinquished property, the clock begins to tick. Typically, investors find the 45 day and 180 day requirements the most stressful in an exchange, but there are different types of 1031 exchanges that can eliminate this kind of headache (this is an advanced topic – please seek professional).

180-day closing window

Once you sell your relinquishing property, the clock starts to tick on both the 45-day and 180-day timers. The IRS requires you fully complete the purchase of your exchanged property no later than the 180th day. This means the property’s deed officially transfers to your name. Both the 45-day and the 180-day windows are STRICT. No exceptions, no extensions, if, and’s, or but’s! If you do not complete any of these requirements, you will not qualify for the 1031 exchange.

No access to proceeds – Qualified Intermediary

When your relinquished property sells, you will not be able to touch any of the proceeds – these funds can never enter your bank account or any account that you control. When executing a 1031 exchange, the proceeds from a sale are held by a QI (qualified intermediary). A QI is a person or company who holds your money while you wait to buy the new property.

1031 Tax Deferred Exchange – The End Game

Typically, 2 things happen for investors who are at the end of their investment careers:

1) Cash out

Some investors at the end of their careers will decide to cash out completely. They sell their entire portfolios and decide it’s time to redeem that IOU slip to Uncle Sam. However, not only is the final sales price taxed, but every purchase prior in the 1031 exchange chain is taxed. Because the cost basis is carried forward on every purchase in a 1031 exchange chain, the final tax bill is almost always exceptionally large.

I don’t recommend this path unless you are in dire need of cash so let’s talk about how you can avoid it – forever!

2) Die and pass on inheritance

Asset preservation has been a popular buzzword in the real estate investment world – how do we pass on our wealth to our next generation? Many investors will hold onto their properties for the entirety of their lives. When they pass away, our current inheritance laws allow your beneficiaries to inherit your real estate assets at a “stepped up” basis which means all previous deferred tax payments on that 1031 exchange chain is completely wiped out.

For example:

Your initial 1031 exchange chain started with a $200,000 initial investment (called cash basis) and through multiple 1031 exchanges, you were able to defer the capital gains and now you own $2.5M worth of real estate with the initial $200,000 cash basis. $2.5M worth of real estate built from a $200,000 cash basis typically equates to a ton of taxes deferred and owed to the IRS. When your beneficiary receives your inheritance of $2.5M at a “stepped up” basis, the beneficiary is not responsible for the taxes owed on the $2.5M. It’s eliminated completely. He/she receives the inheritance with a cost basis of $2.5M and could sell the real estate the following day for $2.5M and incur no capital gains tax.

Final Thoughts

At almost 2000 words, I’m glad you made it this far. Congratulations! I’m will reiterate this again: I believe the 1031 exchange is the most powerful tool an investor has to create wealth. And although slightly complicated at times, this tax loophole can help launch your investment portfolio and should be considered for those who are in it for the long haul. If you decide to pursue a 1031 exchange, please talk to a tax professional about the tax implications as well as a qualified intermediary about the rules and requirements for the 1031 exchange. Best of luck and happy investing.

Disclaimer: I am not an accountant or expert in the US tax code. Any information within this website is for informational purposes only and is not a substitute for obtaining accounting, tax, or financial advice from a professional. Online readers of this information are encouraged to seek out professional advice prior to performing any actions based on the information provided in this article.

Have any questions about the article? Visit me at my website https://edwardseid.com/or http://facebook.com/seidrealestate