Overview of 1031 Exchange
Real estate investors who want to sell a property without having to pay capital gains can use a 1031 exchange. A 1031 exchange (the name comes from Internal Revenue Code section 1031) defers the capital gains tax until a future date if the proceeds from the sale are used to acquire a “like kind” property within a specified period. The term “like kind” just means the next property acquired is of a similar nature but not necessarily the same grade or quality, however, both properties need to be located within the United States. If you sold a duplex you could use the proceeds to buy a fourplex or a commercial building or a car wash, but you can’t buy bitcoin or a classic corvette as these are not "like kind" investments.
1031 Exchange Example
Let’s see how the 1031 exchange works in practice. Natasha buys a property in Utah for $100,000. Later she sells the property for $300,000 with a $200,000 capital gain. She then acquires a $500,000 property in Texas. She carries forward the $200,000 capital gain from the Utah property to the Texas property. Natasha does not pay any capital gains on the sale of the Utah property.
A few years later Natasha sells the Texas property for $750,000 and buys a $1 million property in Montana. The new Montana property has the carried forward capital gain of $200,000 from the Utah property and the carried forward $250,000 capital gain from the Texas property. If she sells the Montana property in a regular sale for $1.1 million two years later this is how her capital gains would be taxed:
$200,000 capital gain carried forward on Utah property
$250,000 capital gain carried forward on Texas property
$100,000 capital gain on Montana property
Total capital gains $550,000
As you can see from the example above 1031 exchanges can be repeated, allowing investors to roll their capital gains forward multiple times on successively larger properties. The capital gains is paid when a property is sold without using a 1031 exchange or is possibly eliminated if the property is passed on to heirs. However, the taxes owed on inherited property may be changing as the Biden Administration is currently reviewing how taxes will apply to appreciated assets passed to heirs, more on that below.
1031 Exchanges Only Work When Done Properly
There are a few requirements with 1031 exchanges that investors need to understand. The investor is required to identify to the Internal Revenue Service a replacement property that they intend to buy within 45 days of the sale of the first property. In addition, the investor needs to close on the new property within 180 days of selling the first property. That is why 1031 exchange investors are sometimes in a hurry to close; if you fail to close within 180 days your gain will most likely be subject to capital gains taxes. It may be worth paying a little more for a property to ensure you close on time to avoid the more costly capital gains taxes that would have to be paid.
Qualified Intermediary
A 1031 exchange also requires bringing in a qualified intermediary to manage the transaction before you sell the original property. The qualified intermediary sells the property on your behalf and receives the proceeds from the sale, so the money never comes into your hands. The qualified intermediary then acquires the replacement property and transfers it to you. If this process is not done correctly the investor will be subject to capital gains taxes.
There are qualified intermediaries in most real estate markets who can be hired for a fee to manage the 1031 exchange for you. Before you hire an intermediary, make sure you understand all the fees that will be charged for the transaction. Complicated 1031 exchanges will incur more fees and your qualified intermediary will likely keep the interest earned on the money they are holding from the sale of the property as part of their fee structure.
Benefits of 1031 Exchanges for the Economy
The 1031 exchange plays a valuable role for newer or small-scale investors looking to scale up their investments by reducing the amount of cash needed to acquire more expensive properties. An investor who has a property with $200,000 in capital gains generating $3,500 in annual cash flow could use a 1031 exchange to purchase a $1 million property generating $35,000 in annual cash flow without having to come up with any additional cash. The capital gain carried forward would cover the necessary down payment. A 1031 exchange, when used correctly, can rapidly accelerate your ability to reach financial freedom.
1031 Exchanges Also Defer Depreciation Recapture Tax
Another benefit of the 1031 exchange is the ability to carry forward the depreciation recapture tax on the property. Real estate investors take a tax deduction for depreciation on their real estate each year. Once they sell the
property the Internal Revenue Service “recaptures” the depreciation that was taken. Hence, if you took $100,000 in tax deductions for depreciation over several years you might owe $25,000 in taxes when you sell the property. By using a 1031 exchange you are able to defer the depreciation recapture taxes to a future date. Again, this helps an investor to grow their investment portfolio quicker by transferring most of the proceeds from the sale into their next acquisition.
Changes May be Coming to 1031 Exchanges
As indicated above, the Biden administration has outlined a plan to raise taxes on households earning more than $400,000 per year. For a recap of those proposed tax changes see here. The President is also looking to raise taxes on real estate transactions with gains of $500,000 or more and may limit the use of 1031 exchanges for transactions below this threshold. If this tax change goes into effect it may limit who can utilize 1031 exchanges and narrow the types of real estate deals that can benefit from a 1031 exchange to sales with less than $500,000 in gains. To provide some perspective, according to Bloomberg, the 1031 tax break will save corporations $2.4 billion and individuals about $5.7 billion in taxes this year, so this proposed tax change will have a significant impact on the real estate sector.
Alternatives to 1031 Exchanges
If 1031 exchanges become less common there are still other strategies for tapping into the real estate equity without having to pay capital gains. The first way is using a cash out refinancing to withdraw equity. For example, if you have a property worth $400,000 but with a mortgage of $50,000 you could refinance the property with a new $200,000 mortgage and walk away with $150,000 in cash. The $150,000 can be the down payment on your next property or invested in other assets. Since refinancing is not a taxable event you would not owe any capital gains or depreciation recapture tax. You are also not required to reinvest the money in a specific timeframe like with a 1031 exchange.
A second strategy to avoid paying capital gains taxes is to sell your primary residence. If you have lived in your primary residence for two of the last five years you could sell the property and pay no taxes on the first $250,000 in capital gains if you are single and $500,000 if you are married and file a joint return with your spouse. The Internal Revenue Service publication 523, Selling Your Home, provides rules and worksheets to explain this process.
A primary residence that you live in is not eligible for depreciation so there would be no depreciation recapture tax due. Selling your primary residence can be a great way to jump start your real estate investing goals. For example, if you and your spouse bought your primary residence for $200,000 that is now worth $700,000 you could unlock $500,000 in tax free gains by selling. You would then buy a new $500,000 primary residence using $100,000 as a 20% down payment. The remaining $400,000 could be invested to acquire multiple rental properties.
One of the keys to becoming financially free through real estate is understanding the tax advantages of tools like the 1031 exchange and the capital gains free sale of primary residences, as well as other tools like cash out refinancing. If you are interested in learning more about real estate investing consider the book Become Loaded for Life and see the articles in the Real Estate section on www.loadedforlife.com.
