I’ve been investing in real estate for almost two decades now, and in that time, I’ve learned quite a few tricks of the trade. One of the most notable is the 1031 exchange capital gains deferment strategy. It’s a clever and legal way to postpone paying capital gains taxes on the sale of a property by reinvesting the money from that sale into a like-kind property.
This may sound like an easy way to avoid paying taxes, but there’s actually a lot to know about using a 1031 exchange the proper way. This includes following certain IRS guidelines, knowing how to use a 1031 with mortgage funding, and so on. I’ll dive into these specifics, and more so you’ll have a well-rounded view of what a 1031 exchange is and how to put this tax-saving tool to good use – let’s begin with the basics:
What Is a 1031 Exchange and Who Can Benefit?
A 1031 exchange, which is also referred to as a like-kind exchange, is a tool that allows investors to sell a property and postpone paying taxes on the gain, and then use those proceeds to reinvest into a “like-kind” replacement property.
Like-kind refers more to the nature or use of the property, not the condition or type of building. For example, the property that’s being sold might be a residential rental property while the replacement is a small apartment complex – they’re not alike in size or how they look, but similar in function since they’re both investment properties. Also, keep in mind that in addition to being like-kind, the replacement property must also be located within the United States.
Allowable exchanges include residential rental properties, as well as commercial use properties and land. Personal properties were previously allowable but were excluded under the Tax Cuts and Jobs Act.
Before we go any further, if you’re unfamiliar with what capital gains taxes are, take a moment to read my article to get caught up – A Guide to Capital Gains Tax – Rates & Reduction Strategies.
Why a 1031 Exchange is Attractive to Investors
Investors typically interested in taking advantage of a 1031 exchange capital gains strategy do so to upgrade to a rental that will have better cash flow and a higher return on investment (ROI). As you can imagine, significant investment growth can occur over time with each exchange that takes place, all while avoiding dishing out capital gains taxes to the IRS.
It’s a great strategy for someone who wants to simply keep upgrading their assets to more profitable investments. Or for those who didn’t do their research when buying their first rental and later learned it’s not performing well. This is the case because a 1031 exchange will enable an investor to sell the underperforming rental without paying capital gains taxes, and use those funds to buy a more lucrative property. That’s the beauty of it all; instead of sending your money off to the government, you’re able to use the money to advance your investment portfolio. You can read about more reasons investors turn to a 1031 exchange in my post – Guide to 1031 Exchanges.
In contrast to all this, avoiding or deferring taxes in this way is not something that can be done when investing in the stock market. If you sell a stock to buy another, you’re responsible for the gain, if any. This is why real estate is such a wise sector to allocate funds towards – it certainly comes with many beneficial tax benefits. To read more about stocks and real estate, you can bookmark this article for future reading – Best Investing Strategies: Real Estate VS Stocks.
The Basics of a 1031 Exchange: Breakdown of the Process and Guidelines
Now that you have a general idea of what a 1031 exchange capital gains deferment strategy is and why investors can benefit greatly from it, I’ll detail how to put this strategy to use, as well as cover guidelines you’ll have to follow for the 1031 to be valid, and you’ll find that information below:
1. Start By Understanding the 1031 Exchange Rules and Guidelines
Before starting the process, make sure you’re up to speed with Internal Revenue Code (Section 1031), you can find information about this by heading over to the Like-Kind Exchanges Under IRC Section 1031 page on the IRS.gov website. I’ll cover some of the main guidelines below, but it’s important to read over this document so you’re well aware of all the rules pertaining to a 1031 exchange.
2. Consider Which Property You Should Sell
Before looking for a rental property to buy or selecting a qualified intermediary, which I’ll detail soon, it would be a good idea to determine which property would be best to sell. You may only have one rental, so no considerations would be needed. However, if you own several, it’s worth the time to crunch the numbers to ensure you’re selling a property that you can do without. Also, make sure you research the market the property is sitting in first. If you sell a property that’s in an up-and-coming housing market, you could lose out on some potential big profits later on down the line.
3. Identify Replacement Properties or a Location of Interest
Before selling your property, it would be a smart move to at least pinpoint the location you intend to buy in. This should be done with careful consideration of how well the housing market is doing, the economy in the area, the job market, population growth, rental demand, and the like.
You may even find a property that fits well with your investing goals, but I recommend selecting at least three. Why? Because one of the guidelines is that you’ll have to inform your Qualified Intermediary of the specific replacement property you intend to buy within 45 days and complete the purchase within 180 days, and I’ll go into more detail on that later. So, if you have a few properties lined up ahead of time, this will up the chances of one being available by the time your property sells. When searching for a new property, be mindful of the fact that the replacement property must be of equal or greater value than the property that’s being sold.
4. Select a Qualified Intermediary (QI)
Ok, now for some information on the Qualified Intermediary that I touched on earlier. A QI, also referred to as an exchange facilitator, takes care of some key components for the investor. It’s essential to hire an experienced QI to make sure deadlines are not missed and everything is done correctly to ensure no capital gains taxes will be owed.
A QI is also needed to handle the funds for the investor. This is the case because the proceeds of the property that will be sold should never be in the hands of the investor in any way shape or form. It must go from the previous property to being handled by the QI, and then the QI takes the necessary steps to transfer the funds to invest in the new property, provide title or escrow documents, and the like. The investor not handling the money themselves is all part of the mandatory guidelines that will allow them to avoid owning taxes on the sale.
5. List and Sell the Relinquished Property
Now that you understand the ins and outs of a 1031 exchange, have a professional QI on hand, and have a property or location that you would like to buy in, it’s now safe to list and sell your rental property.
6. Identify and Purchase the Replacement Property Following the 45 & 80-Day Rule
Now that the property has sold and the funds are available, the investor has 45 days from when escrow closes to inform the QI of which replacement property they intend to purchase. The 45-day timeframe is referred to as the identification period. In addition to this, the investor has a total of 180 days to buy the replacement property, and this countdown starts when escrow closes on the relinquished rental, meaning, it includes the 45-day identification period.
These timeframes are the reason why it’s so important to prepare ahead of time by understanding the process and having an idea of where the replacement property will be located. If everything is not completed according to the specified timelines, the entire transaction can be deemed disqualified and the investor will owe capital gains taxes.
7. File IRS Form 8824
The last step is to report the 1031 exchange by filing IRS Form 8824 when you file your taxes. You’ll be expected to provide descriptions of the two properties, provide dates and prices of the sale and purchase, if a gain or loss was recognized, and so on.
Taking all the right steps can ensure your 1031 exchange capital gains tax deferment goes as planned. With that said, be sure to work closely with your QI to streamline the process and keep it on track.
Avoiding What’s Called a “Mortgage Boot”
Because doing a 1031 exchange with mortgage financing is not uncommon, I’d like to touch on this a bit. Why? Because if you don’t play your cards right when using a mortgage, you’ll end up owing capital gains taxes.
When a mortgage is used with a 1031 exchange, equity and debt are rolled over from the relinquished property to the replacement property to postpone capital gains taxes. However, a mortgage boot can occur if the replacement property ends up having less debt than the property that’s being sold.
For example, let’s say you sell a rental property with a $500,000 mortgage and purchase a replacement property that only has a $400,000 mortgage, there would be a $100,000 difference or shortfall, which would be considered a mortgage boot. The investor would then be responsible for capital gains taxes on the $100,000. The whole point of doing a 1031 exchange is to defer paying capital gains taxes, so the investor should take certain steps to make sure a mortgage boot does not occur.
To avoid a mortgage boot, it’s important that the debt on the property that’s being purchased is equal to or greater than the debt on the property you’re selling. An investor can do this by purchasing a property that has an asking price that’s greater than the relinquished property, or by securing additional financing on the rental they’re buying to cover the shortfall.
If you’re not experienced with utilizing a 1031 exchange with mortgage financing, I suggest consulting with a qualified tax advisor or 1031 exchange expert who can help you structure the deal so you can be 100 percent sure to avoid paying capital gains taxes.
Additional Investment Resources
- ROI Calculator for Investors: Calculating Profits on Rental Properties
- Tax Shelters for Real Estate Investors Who Want to Safeguard Their Wealth
- Tax on Unrealized Gains: An Unconstitutional and Dangerous Precedent
- Why Investing in Rental Real Estate is a Wise Strategy for Wealth Building
Grow Your Net Worth by Incorporating a 1031 Exchange Into Your Investment Strategy
I know from past experience that using the 1031 exchange capital gains deferment strategy is a great way for investors to grow their portfolios and build wealth. When you have a full understanding of the process, stick to IRS guidelines, as well as get professional help and advice from experienced Qualified Intermediaries and tax advisors, investors can avoid costly mistakes and maximize profits.
If you don’t know what to look for in a tax advisor who can assist with your 1031 exchange, be sure to get up to speed through my post – Finding the Right CPA for Real Estate Investors: What to Look For. Also, if you’d like a recommendation, I use Tom Wheelwright, CPA of WealthAbility. He’s the personal accountant for real estate giant Robert Kiyosaki. You can connect with Tom and his team through our Lower Your Taxes informational page, or grab his book Tax-Free Wealth for some tips that can save you a ton of money.
Morris Invest Can Provide a Lucrative Replacement Property for Your 1031 Exchange
The opportunity to reinvest proceeds into like-kind properties without incurring immediate tax liabilities is just one of the many things that sets real estate apart from other investments. If you’re planning on doing a 1031 exchange and need a lucrative replacement property to complete the process, we can help.
Morris Invest is a full-service investment company that builds new construction rental real estate in locations with a high rental demand and a booming economy. Feel free to contact Morris Invest so we can help you find the perfect replacement property for your 1031 exchange. Also, take a moment to dive into our power resources, which includes the Financial Freedom Academy and our Freedom Cheat Sheet.
Before you go, be sure to watch my video for more details on using a 1031 exchange to defer capital gains taxes:
