What Are the Benefits of a 1031 Exchange?
Renters Warehouse Blog
Looking for a way to save on taxes? Most real estate investors are happy to employ any strategy that allows them to save on their tax bill.
One tax reduction strategy that you’ll often hear thrown around is the “1031 exchange” which allows you to postpone the amount that you owe on tax. But what is this mysterious exchange? How does it work? And is it as good as it sounds?
When you sell an asset or investment for more than you acquired it for, the profit you make is subject to capital gains taxes. In real estate, these figures can be huge. This can affect your bottom line, reduce your returns, and weaken your ability to purchase more income-producing assets.
A 1031 exchange though, makes it possible to defer, or postpone, a great deal of tax. Sometimes indefinitely. With this in mind, let’s take a look at some tips to help you get the most out of a 1031 exchange. Discover how it works and how it can benefit you.
What Is a 1031 Exchange?
The 1031 exchange takes its name from Section 1031 of the Internal Revenue Code.
Contrary to what some may think, it’s not a tax loophole. It’s a perfectly legal procedure that allows you to sell your investment property and defer capital gains taxes, as long as you reinvest the proceeds by purchasing a “like-kind” property or properties within a certain time period. Normally, the IRS doesn’t allow 1031 exchanges for properties that are used as a primary residence. However, there are some exceptions to this rule that can qualify some primary residences for exchange.
For a lot of investors, this is an excellent way to build a portfolio, grow their wealth, or swap underperforming assets for high-yield ones.
There’s also no limit on how many times you can do a 1031 exchange. You can continue to sell and exchange properties as often as you like, as long as you hold on to them for at least two years. Your initial investment continues to grow and you can profit from each of the swaps until the day you finally decide to sell for cash.
Why Should You Use the 1031 Exchange?
To Reset Depreciation
The IRS recognizes that real estate assets, especially residential real estate, wear down over time. When declaring taxes from rental income, investors can claim depreciation as an expense and get deductions. However, if you decide to sell your rental property you would have to recapture the depreciation and pay taxes on it. This usually comes up at around 25%. With the 1031 exchange, the depreciation is carried over into the replacement property and is deferred until a taxable sale of the replacement property occurs.
To Free Up More Capital
Tax savings mean more buying power available for you to invest in other assets. You can leverage your cash and get a more expensive, high-value replacement, using the proceeds of the exchange as a downpayment.
For Portfolio Diversification and Expansion
It’s a piece of common investment advice: don’t put all your eggs in one basket. Owning just one asset, or several of the same type, exposes you to more risk in case the market goes down. Because you can purchase several properties through a single 1031 exchange, you can diversify your assets and reduce the risk of owning just one or one type of property.
To Consolidate Properties
On the flip side, some might want to do the opposite. Owning too many properties at the same time can be costly and time-consuming, especially if the returns aren’t looking so great. If at some point your investment goals have changed or you’re having trouble managing and maintaining several properties at the same time, you can increase your profits and efficiency by using the 1031 exchange to swap high-maintenance properties for something that takes less time and energy to manage. Of course, if you want to step back even further, you can also hire a property manager to help you out.
Increased Cash Flow and Income
Aside from building wealth through capital appreciation, owning a property with positive cash flow is a great way to grow your money quickly. You can exchange a property that generates no income (like vacant land) for a commercial building or rental property that gives you monthly income and positive cash flow.
For Tax-free Transfer of Assets and Profits to Your Beneficiaries
We mentioned that the only time you’ll pay the deferred taxes is when you sell. However, if an investor chooses to hold on to the replacement property for a long time, in the event of death, the deferred tax is erased when the profits and property are transferred to your beneficiaries. This makes this strategy a great way to build multigenerational wealth.
Important Things You Need to Know About the 1031 Exchange
Like everything that deals with taxes and contracts, the 1031 exchange has its own set of guidelines and rules that you should follow to avoid bad deals or problems with the IRS. This relates to the type of properties involved, middlemen, and timelines.
What Qualifies As Like-Kind Properties?
The key prerequisite to do the 1031 exchange is that you can prove that the relinquished and replaced properties are both for investment. This is what the IRS refers to as “like-kind” properties. This can mean either developed or undeveloped real estate. It also isn’t necessary for the properties to have the same functions.
You can sell a commercial building and replace it with rental properties, or exchange vacant land for a duplex. An Improvement or Build to Suit Exchange is one type of exchange that allows you to use the proceeds from the sale of your property to construct something new or renovate the property you plan on buying. Reverse Exchanges are also possible. This is when the replacement property is bought before you relinquish your property.
For primary residences, Section 121 of the Internal Revenue Code will only allow 1031 exchanges as long as you meet their ownership test and use test. This means that immediately after the exchange, in each of the 12-month periods you have to rent out the unit for 14 days or more, and your personal use of the unit should not be greater than 14 days or 10% of the number of days within the 12-month period it is used as a rental.
Are you considering investing in a property with existing tenants? Read Buying a Property That Already Has Tenants
The Role of Qualified Intermediaries
Because the transaction is an exchange, you can’t handle any of the cash proceeds. To complete a 1031 exchange, you need an IRS-approved “middleman”, called a qualified intermediary (QI). IRS policy also states that it can’t be your children, parents, or anyone who works for you as an agent including your lawyer, accountant, or real estate broker. The QI sells your asset on your behalf, buys the replacement property, and then transfers the deed to you. Part of the QI’s responsibilities also includes preparing legal documents and ensuring that everything complies with IRS guidelines. For reverse exchanges, the intermediary is called the Exchange Accommodation Titleholder (EAT).
Important 1031 Exchange Timelines
45-Day Identification Period- This rule is related to the selection of the replacement property. Once you sell the property, you have 45 days to designate the replacement property to the intermediary. This should be done in writing.
180-Day Closing Period - This one is the deadline for the closing on the replacement property. The exchanger has to do this within 180 days of selling the property or on the due date for tax return filing for the year in which the property was exchanged.
Note: The counting of the 45 and 180 days starts simultaneously from the moment you sell your property. For example, if you sell your property, identify the replacement 45 days later, you have 135 days left to close on it.
How Many Replacement Properties Can I Choose?
- Three Property Rule - You can identify three properties as potential replacements, regardless of their market value. You can take just one or all three.
- 200% Rule - This lets you identify an unlimited number of replacement properties, as long as the cumulative value doesn’t exceed 200% of the property being sold.
- 95% Rule - This allows you to choose as many properties as you like, as long as you acquire the properties valued at 95% of their total or more.
Finding the best replacement property for investment within 45 days is no easy feat. To give you some ideas on how to do this quickly and efficiently, check out our free guide on How to Find and Buy the Perfect Investment Property.
Value Difference Between Properties and the “Boot”
To defer all capital gain taxes, the net sale of the property you buy must be of equal or greater value than the one you are selling. If the replacement property is of lesser value, the difference that isn’t reinvested, called the “boot,” is taxable.
For example, you sell an apartment complex for $250,000. You do a 1031 exchange for another rental property that costs $200,000. There’s a difference of $50,000, but you decide to keep it as cash. You have to pay the capital gains tax for the $50,000. Purchasing personal property or non-like kind property can also be done to complete the transaction, but it also qualifies as boot.
Mortgaged properties can be exchanged but the amount needs to be taken into consideration. If the mortgage on the replacement property is less, the difference is treated as cash boot.
Some fees and expenses incurred during the exchange can be paid for using the difference in exchange funds. This include:
- Filing fees
- Legal fees
- Finder fees
- Broker’s commission
It’s important to note that it cannot be used for financing fees, property taxes, repair costs, or insurance premiums.
One of the things that makes investing in real estate so attractive is the number of valuable tax benefits and write-offs that are available. Knowing about them helps you to strategize better to increase your ROI and to build wealth. Benefitting from extra leverage, portfolio diversification, and increased cash flow make the 1031 exchange an excellent tool that you should take advantage of.
Are you looking to do an exchange to upgrade some assets in your portfolio? At Renters Warehouse, our Market Research Center gives you access to housing market data across the country. See our available inventory to find investment properties that meet your investment criteria.
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