21 Jun How Some Investors Use 1031 Exchanges to Defer Capital Gains Tax and Build More Wealth
You may have heard some real estate investors talk about a 1031 exchange. A 1031 exchange is essentially taking the proceeds of an investment property sale and using it to buy another investment property, while deferring the capital gains taxes. A properly executed 1031 exchange essentially creates an interest-free, no-term loan from the federal government. Instead of paying the taxes now, you can invest those dollars in one or more investment properties. A real estate investor could perhaps even avoid paying the taxes at all if they pass away and have their heirs inherit the property.
The term 1031 exchange comes from Section 1031 of the IRS code. There are a number of rules, strict time frames, and tax implications. Let’s dive into the details.
If you own real property for a year or less and then sell it for a profit, you normally have to pay short term capital gains tax (equivalent to your ordinary income tax rate). If you owned the property for more than a year and then sell it, then you would have to pay long term capital gains tax. That is 15 percent for most people and 20 percent for the most wealthy ($492,300 or more in earnings for single filers in 2023; $553,850 or more for those married, filing jointly). Another tax is depreciation recapture. If you took depreciation, then that is taxed as ordinary income.
With a 1031 exchange, you sell a property held for investment or business purposes and then reinvest the proceeds in a “like-kind” property. If done right, you defer paying capital gains taxes. A like-kind exchange does not strictly mean that you have to replace a triplex with another triplex. You can exchange a duplex for raw land, or an apartment building for a strip mall. You can even exchange one business for another business.
Here are the qualifications and rules for a 1031 exchange:
- The property must be held for investment or business purposes.
- The proceeds of the sale cannot be received directly by the investor. A Qualified Intermediary must handle the transaction.
- The proceeds must be reinvested. Any cash proceeds that go to the investor will be taxable.
- The tax basis of the relinquished property carries over to the replacement property. For example, if you sell a property for $500,000 and the basis was $200,000, the basis in the replacement property is $200,000 plus any new debt taken on and any cash paid out.
- There needs to be an equal or greater level of debt in the replacement property as there was in the relinquished property. If not, the investor must either pay taxes on the difference or invest additional cash to offset the lower amount of debt in the replacement property. Any proceeds that the investor receives is called boot, and taxes are owed on that amount. For example, let’s say you had a $2 million mortgage loan on the relinquished property but your loan on your new property is only $1.5 million. You therefore have $500,000 of boot that will be taxed.
- The investor has 45 calendar days from the date of sale of the relinquished property to identify and commit in writing to the replacement property. The IRS states that you can designate three properties as long as you ultimately purchase one of them.
- The investor has 180 days from the date of the sale of the relinquished property to purchase the replacement property. The 180 day timeline runs concurrently with the 45 day timeline, so in essence the investor has to buy the new property within 135 days after the end of the 45 day period. These dates can only be extended if the President declares a natural disaster area that affects the parties involved or the properties.
- The 1031 exchange must be disclosed to the other parties involved.
- Exchanging into multiple properties is acceptable, yet their combined value cannot exceed 200 percent of the relinquished property’s value. For instance, you sell an apartment building for $3,000,000 and decide to buy 15 single family homes at $300,000 each. That is allowable since the value of the 15 houses is less than $6,000,000.
- Just as you cannot go over 200 percent of the value of the relinquished property, you cannot go below 95 percent of the value either. For example, you sell a strip mall for $2,000,000 and identify 10 houses with a total value of $1,900,000.
- All that being said about the 200 percent rule and the 95 percent rule, you can exchange into as many as three properties with no fair market value restrictions as long as the debt-load requirement is met.
- A reverse 1031 exchange is one in which you can close on the replacement property first and then decide to sell what will be the relinquished property. The 45- and 180-day deadlines still apply.
There is no limit on how many times you can do a 1031 exchange. Foreign investors can also utilize a 1031 exchange. The Tax Cut and Jobs Act (TCJA) of December 2017 removed exchanges of personal property, such as airplanes, equipment, and franchise licenses. Only real estate qualifies now.
An investor cannot defer capital gains on an investment property by buying a home that the investor chooses to live in. Investors can defer gains on business equipment as long as they buy that equipment as part of the exchanged property. The replacement property can be residential, commercial, industrial, or even leased property if the lease is for 30 or more years and includes ownership interest.
Typically you cannot perform a 1031 exchange involving a primary residence nor a vacation home. However, there are some loopholes.
- If you stop using a vacation home and rent it for six or more months, then you effectively have converted it into an investment property.
- If you desire to use your replacement property as a primary residence or second home, you cannot move in right away. The IRS established a safe harbor rule, which states that they will not challenge whether a replacement property is qualified if the following conditions are met:
- In each of the two years after the exchange, you must rent the property to another person for fair market value for at least 14 days.
- During the one year period that the property is rented at fair market value, your own use of the property cannot be more than 14 days or 10 percent of the number of days that the property is rented.
If you sell your primary residence and lived in it at least two of the previous five years, the IRS allows the first $250,000 of capital gains (if single) and $500,000 (if married, filing jointly) to be tax-free. However, you cannot just move into your replacement property, call it your primary residence, and then sell it tax-free a couple of years later. (Some people used to do that prior to 2004, when a loophole was closed.) If you do wish to turn your replacement property (say, a beach home used as a rental) into a primary residence to ultimately use the capital gains tax exclusion, you will have to own the property for at least five years after the date of acquisition.
Savvy investors may continue the cycle of 1031 exchanges indefinitely, and by so doing their wealth can grow exponentially. If the investor owns the exchanged real estate until they pass away, their heirs will not have to pay the deferred tax. That deferred tax liability from the capital gains and the depreciation recapture simply goes away. The heirs receive the real estate with a stepped-up tax basis, which is the fair market value of the real estate at the time of transfer to the heirs.
The fair market value of the real estate will be factored into the deceased person’s estate, so there could be federal and state estate taxes.
If you are considering a 1031 exchange or conducting estate planning, consult the proper professionals.
Tai DeSa is a graduate of The Wharton School of the University of Pennsylvania. He became a full-time real estate investor in 2004 after serving in the U.S. Navy. Tai has made colossal mistakes in investing (and learned some things along the way). He has helped hundreds of homeowners avoid foreclosure through successful short sales. Check out Tai’s books on Amazon.com. Tai may be available for coaching and speaking engagements on a variety of real estate topics. Send an email to tai@investandtransform.com.
No Comments