Property investors are known for reeling in tax savings that amount to much more than a simple break from the IRS. If managed properly, their tax liability could potentially be reduced to zero. One strategy used for keeping more money in their pockets is utilizing a 1031 exchange, which can save thousands of dollars come tax time. So, what is a 1031 exchange? It’s a legal tax strategy for deferring capital gains taxes by reinvesting proceeds from the sale of a property into another like-kind property within a specified timeframe.
There are important 1031 exchange rules to keep in mind, as well as benefits you’ll want to be aware of, and I’ll discuss them below. Before diving in, though, it’s worth mentioning that the 1031 exchange has been under attack from previous Administrations who have referred to it as a loophole used to avoid paying taxes. However, their attempts to limit or eliminate 1031 exchanges have been unsuccessful.
A current tax reform bill that recently passed the House of Representatives aims to keep 1031 protections in place. Given the 1031 exchange perceived staying power, it would be worth learning about this tax-saving technique to ensure you are making the most of your investment opportunities. If you’re interested in reading up on the bill, head over to our article, Tax Reform Bill Offers Key Wins for the Real Estate Sector.
Ok, now let’s dive in to learn more about this popular tax strategy…
What is a 1031 Exchange in Real Estate?
A 1031 exchange, also referred to as Section 1031 of the Internal Revenue Code, is an advanced tax-deferment strategy that allows investors to defer paying capital gains taxes on the sale of a piece of real estate. This is accomplished by using the proceeds from the sale of a property to buy a replacement property that’s considered like-kind.
A like-kind property is one that’s similar in nature or function, such as one investment property for another, and has nothing to do with the condition, style, or age of the two properties. Allowable real estate that is most commonly incorporated includes residential properties and commercial buildings, as well as land, just as long as they are designated for business purposes and not personal use.
The bottom line is that when the two like-kind properties are sold and bought within an allotted timeframe, the investor is able to defer paying taxes on the gains of the investment property that was sold.
Now that you have an idea of what a 1031 exchange is used for, I’ll cover the benefits so you’ll understand why so many investors use this strategy.
Also, we have an additional article on this very topic if you’d like to learn more about it: Navigating the 1031 Exchange.
Notable Benefits of Using a Capital Gains Deferral Strategy
The main benefit of a 1031 exchange is the capital gains deferment that allows an investor to hold on to all the proceeds earned from the sale of a property. Although the suppression of the capital gains tax is the reason a 1031 is used, this tax deferment propels several other benefits such as leverage, portfolio diversification, and the ability to fast-track financial growth.
Before we move on, I suggest diving into my article, Guide to Capital Gains Taxes, as well as my post, Tax on Unrealized Gains: An Unconstitutional and Dangerous Precedent for Asset Owners, to get a better idea of things.
As far as leverage is concerned, the capital gain on the sold property, in a sense, is like an interest-free loan from the government that can be used to reinvest into a more profitable piece of real estate. By this, I mean that it allows for underperforming properties to be exchanged for properties that will increase your chances of building greater wealth.
The process also easily enables portfolio diversification where an investor can sell one higher-cost property, such as an apartment complex, and use the money to invest in several single-family homes. Or, if market dynamics are shifting, an investor may want to set up camp in a more lucrative location, and a 1031 exchange will provide the funds to do so.
All in all, investors use 1031 tax-deferred exchanges to sell and buy properties, where each transaction builds upon the last, allowing for significant financial growth at a quicker pace. This all sounds fantastic, but to take advantage of a 1031, you’ll have to ensure you’re following the strict set of rules that have been laid out, which I’ll cover next.
Rules of Section 1031 Exchanges
There are only a few main rules for 1031 exchanges, but they are pretty important and, if not followed, could end up costing an investor thousands of dollars. Here’s a rundown of these rules:
When the investor sells the original property, they must never take possession of the money from the sale. A qualified intermediary (QI) should be utilized to handle the funds for the seller, as well as take care of other elements of the process. For example, the rules state that the investor must inform the QI of the property they intend to buy within 45 days from the close of escrow and purchase that same property within 180 days. That said, it’s important to do your research ahead of time so you’ll have the replacement property ready to move forward on within the specified timelines.
Other 1031 exchange rules include the requirement of the two properties being like-kind in function, and the replacement property should be equal to or greater in value than the property that was sold. If the new property is of lesser value, the investor won’t be able to fully defer the capital gains from the sale. This is especially important when a mortgage is used because if the debt on the new property is less than the previous property, the investor would be required to pay capital gains on the difference.
In addition to this, to use a 1031 exchange, the properties must be for investment or business use only. For the full set of rules and explanations, head over to the official Section 1031 IRS page.
The Like-Kind 1031 Exchange Process
If you’re new to the game, I suggest seeking the guidance of a fellow investor who has experience with 1031 exchanges, as well as obtaining assistance from a qualified intermediary, and a CPA who deals in real estate taxes. If you don’t have a trusted CPA, bookmark my article, Finding the Right CPA for Real Estate Investors.
Even with the help of a few professionals, you should have a general understanding of the process yourself, so I’ll cover that below. But first, take a moment to watch this short video that provides a few 1031 tax deferred exchange tips:
Step 1: Make Sure You’re Selling and Buying the Right Properties
First, you’ll want to determine what property you’d like to sell. In doing so, be sure you’re not selling a piece of real estate that’s in an up-and-coming neighborhood with substantial financial growth potential. Once you determine if you should let a property go or not, you’ll want to do the same research when it comes to buying a property. It’s essential to look over all elements to determine profitability – the local economy, rental demand, vacancy rates, crime rates, job market, and so on.
I also suggest selecting more than one property to buy in case the first deal falls through during the purchase process, which is important because you’re dealing with a timeline. As for calculating profitability of the new property, you’ll want to rely on some tools. Below, you’ll find a few articles that may help:
- Calculating ROI: Tools and Techniques for Real Estate Investors
- Real Estate Metrics for Investors: GRM, NOI, and IRR Explained
- Analyzing Rent to Price Ratio: Metrics, Significance, and Application
Step 2: Hire a Qualified Intermediary
As mentioned, you’ll need to hire a qualified intermediary. Now, this can be done even before you start Step 1; you’ll just need to make sure you have one lined up in time to handle the money from the sale of the property. If you’ve never done a 1031 exchange before, I recommend hiring one from the start so they can assist you with the process. Also, the IRS provides a Qualified Intermediary List that can help speed up the process of obtaining one.
Step 3: Sell the Original Property and Inform the QI of its Replacement
After completing Step One, where you’ve decided upon a property to sell and buy, and Step Two is completed, you’ll be able to move forward with selling the property. At this time, you would inform your QI of which property you’ll be purchasing, and you’ll have 45 days from the close of escrow to do so. Your QI should keep the process moving forward, ensuring you don’t miss any deadlines.
Step 4: Purchase the Replacement Property
When it’s time to purchase the replacement property, your QI will transfer the funds, and take care of the necessary elements such as title, escrow, and the like. As noted above, 1031 exchange rules state that you’ll have 180 days to purchase the replacement property, with the count starting the day escrow closes on the sold property.
Step 5: Include IRS Form 8824 With Your Taxes
After the new property has been officially purchased, the final step would be to inform the IRS of the 1031 exchange. This is done by filing IRS Form 8824 with your taxes. The IRS also provides Form 8824 instructions for those who are unfamiliar with this document. However, I highly recommend having your CPA take care of this step for you.
Before we wrap things up here, I’d like to provide you with a few more articles and resources that can help lower your tax burden.
- WealthAbility’s Financial Education and Tax Strategies
- Tax Shelters for Real Estate Investors Article
- Powerful Benefits of a 1031 Exchange Podcast
Increase Your ROI Using Advanced Tax-Deferral Strategies
I hope this article has answered your question as to what is a 1031 exchange in real estate and how the process works. Many investors are unaware of this tax strategy and they are losing substantial amounts of money because of it, as well as losing out on valuable opportunities. If you take one thing away from this article, it should be that a 1031 exchange allows you to keep moving forward with leveling up your ROI, net worth, and your portfolio, so it’s worth learning the ropes.
If you currently have a property that you’d like to utilize in a 1031 exchange, and you’re seeking out a profitable replacement property, our team can help. We build new construction rental properties that typically yield 18+ IRR, and are located in areas that have a high demand for rentals, as well as sport booming economies.
We spend years researching markets and won’t set up camp in one until we know 100 percent that it’s a high-performing location. As an example, here’s an article on one area we currently build in: Lubbock Recognized as Recession-Proof City and Maintained a Strong Texas Rental Market Throughout Pandemic.
Feel free to contact our team if you have any questions regarding how a 1031 tax deferred exchange works, or if you’d like to hear more about our build-to-rent properties. In the meantime, dive into the following video that showcases one of our new construction rental properties:
