1031 Exchanges: Understanding the Rules and Benefits for Real Estate Investors
What is a 1031 Exchange?
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value. This allows investors to defer the capital gains tax from a sale of a property and invest the proceeds into another property, often called “trading up”.
For example, an investor purchases a property in 2015 for $1,000,000, then by 2020 the property appreciates to $1,750,000 and the investor decides to sell. The capital gain from that sale is $750,000, and tax will have to be paid on that gain. If the investor decides to utilize a 1031 exchange, they can invest the entire sale proceeds of $1,750,000 into another property and defer paying taxes on the gain.
Why You Should Utilize a 1031 Exchange
As an investor, there are a number of reasons why you may consider utilizing a 1031 exchange. Some of those reasons include:
- You may be seeking a property that has better return prospects or may wish to diversify assets.
- If you are the owner of investment real estate, you might be looking for a managed property rather than managing one yourself.
- You might want to consolidate several properties into one, for purposes of estate planning, for example, or you might want to divide a single property into several assets.
- You can reset the depreciation clock (explained below).
1. Tax Benefits
The main benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange allows you to defer capital gains tax, thus freeing more capital for investment in the replacement property. In a 1031 tax deferred exchange type of transaction, you sell one property and defer the payment of capital gains taxes by acquiring a replacement property or properties. This helps you keep the money working for you, rather than paying out about a third of that equity in taxes.
What is a “like-kind” property?
The term “like-kind” is commonly used when discussing a 1031 exchange because the tax code specifically refers to “like-kind” exchanges, but this term is perhaps the most misunderstood phrase in all of real estate. Too many people perceive “like kind” to be real estate specific, i.e. a residential rental needs to be exchanged for a residential rental or raw land can only be traded for raw land. This is a misconception; the term “like kind” in this section takes on a less specific meaning.
Any real estate held for investment or commercial purposes can be exchanged for any other real estate used for the same purpose. This allows the owner of a residential rental returning 4.5% or even negative cash flow raw land to upgrade into a triple net (NNN) leased investment grade commercial building paying 6%.
Consider this real-life example: A Nashville couple owned a residential rental that generated $1,700 per month of income. From this revenue the couple paid taxes, property insurance, water and garbage fees. Additionally, they had the expenses of re-painting and replacing the carpets with new tenants. After all was said and done, they realized less than $1,400 per month in real income. The husband managed the tenants and property and the wife kept the books. After utilizing the power of a 1031 Exchange this couple owns portions of a regional bank and a dollar store. Both properties have long term leases in place and the couple receives $2,100 every month, deposited directly into their bank account – guaranteed by two of the most secure corporations in America. This 1031 transition created a 50% increase in net monthly revenue without the hassle of property management, thus creating a stream of passive income they can enjoy in perpetuity.
2. Ability to Reset Your Depreciation
As a property owner, you can write off “depreciation” of your asset to compensate for deterioration related to the wear and tear, aging or other structural obsolescence of the property. For example, the IRS recognizes 27.5 years as the depreciable time period for an investment property (your CPA can describe other acceptable methods). This means that every year, the amount of the value of your “improvements” (the value of the building) divided by 27.5 can be deducted from ordinary taxable income for 27.5 years. Translation: You have the potential to reduce the amount of income taxes you pay because of depreciation.
When you sell an investment property, you’ll pay some hefty capital gains taxes at the time of the sale if you have gains. Further, accumulated depreciation recapture hangs around until the last mile and is taxed at a federal rate of 25%, with varying results at the state level. However, you won’t owe any taxes at the time of sale if you execute your 1031 deferred exchange sufficiently. In a 1031 deferred exchange, your CPA may elect to reset the depreciable amount of your investment property to a higher value that would give you a bigger tax benefit.
3. Exposure to New Markets and Portfolio Diversification
Want to invest in a market with growing potential? Like-kind exchanges aren’t constrained within state lines. This means you can capitalize on one of real estate’s best advantages, which is the diversification of risk. Getting your foot in the door of an up-and-coming market early could lead to bigger returns down the road.
Related to the above benefit, a 1031 exchange may allow a passive investor to exit out of a single managed property and into a variety of passive investments, spreading risk across markets and reclaiming time that otherwise would have been spent maintaining and managing property. An investor could take one high value property, and buy multiple properties with higher returns.
4. Trade up for Higher-Value Properties
A 1031 deferred exchange lets you trade up to a property or portfolio of properties with higher returns or qualities that better match your investing goals — and you won’t have to pay tax on the new investment until you sell (unless you choose to do another 1031 exchange).
For example, one Roofstock customer was able to double his investment property cash flow by doing a 1031 exchange from a single commercial property into a large portfolio of single-family rental homes. Some of the most astute real estate investors have 1031 exchanged single-family homes in highly appreciated, high-tax markets, such as California, in order to purchase a portfolio of rental properties in lower volatility/more affordable states with better cash flow, which can generate greater returns over time.
The Role of Qualified Intermediaries
Under Section 1031, any proceeds received from the sale of a property remain taxable. For that reason, proceeds from the sale must be transferred to a qualified intermediary, rather than the seller of the property, and the qualified intermediary transfers them to the seller of the replacement property or properties.
A qualified intermediary is a person or company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. The qualified intermediary can have no other formal relationship with the parties exchanging property.
The Bottom Line
A 1031 exchange is a tax-deferral tool that real estate investors can use to:
- Build wealth,
- Save on taxes, and
- Expand their portfolio
This strategy is applicable to any investor wishing to sell an existing property and trade up for higher cash flow. At Excelsior Capital, we’ve seen the power of this investment vehicle first-hand. If used properly, the ability to defer the capital gains tax and use the entire proceeds from a sale to buy larger properties through 1031 can be an amazing tool for building wealth over a lifetime. 1031 exchanges can also be used to completely avoid paying the deferred capital gains taxes by passing the property down to your heirs when you pass away.
If you are planning to sell an investment property you own or plan to accumulate properties throughout your lifetime, the benefits of utilizing a 1031 exchange make it worth considering. And if you determine that a 1031 exchange is right for you, then it is important to work with qualified professionals to ensure all the rules are being followed. Reach out to us if you have additional questions!
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