Investing in real estate can be a highly profitable enterprise. Unfortunately, real estate investors know that it comes with the same cost as most other forms of investment: taxes. Fortunately, unless Congress changes the 1031 rules, which have been in existence for more than 100 years, there is a way for savvy real estate investors to defer payment of capital gains taxes indefinitely: the 1031 exchange.
Named after the section of the Internal Revenue Code that defines its many rules and regulations, the 1031 exchange permits an investor to defer tax payment by following a series of strict rules. What follows is a list of what you need to know in order to take full advantage of a 1031 exchange.
1. 1031 Exchanges Are Also Known as ‘Like-Kind’ Exchanges, and That Matters.
Section 1031 of the IRC (opens in new tab) defines a 1031 exchange as when you exchange real property used for business or held as an investment solely for another business or investment property that is the same type or “like-kind.” As the code makes clear, real properties are generally viewed to be “like-kind,” and the seller of a business property can successfully defer the coming of the Tax Man by investing the proceeds of the sale into a subsequent business property. A seller of raw land can consider a rental home as “like-kind,” and someone who is selling an apartment complex can buy a medical building, and it, too, will be “like-kind” under the 1031 rules.
The simplest way to understand it: You’re swapping one property for another, and in doing so, the second property assumes the cost basis of the first property. The code is designed to facilitate the reinvestment from one piece of real estate into another, but in keeping with the “like-kind” requirement, an investor cannot use the proceeds of a real estate investment to purchase a different form of investment, like stocks or bonds. However, in some cases, certain oil and gas interests could be considered like-kind.
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2. Careful: You’re on the Clock!
When contemplating a 1031 exchange, the race is indeed to the swift, or at least to the efficient: You have 45 days from the date of the original property’s sale to identify a new property to reinvest the proceeds. And you have only 180 days from the original sale date to close the deal on the new investment property. (Remember, that’s 180 days from the original sale date, not 180 days from the identification of the new property!) Miss either one of these deadlines (like identifying the new property on day 46, or closing the new deal on day 181), and you’ll be liable for capital gains taxes on the first transaction. No exceptions. To help with that, here’s an excellent free infographic that you can download about the typical 1031 exchange timeline (opens in new tab).
3. 1031 Exchanges Don’t Work to Downsize an Investment.
The strict rules surrounding 1031 exchanges require the new investment property to be of equal or greater value than the property being sold. Additionally, for a full tax deferral, the entire proceeds of the sale must be used to purchase the second property.
So if the first sale goes through for $250,000, you can’t reinvest $200,000 into a new property and pocket the $50,000 difference; the entire $250,000 must be included in the second transaction. If it’s not a property of equal or greater value, the capital gains tax will apply to the entire applicable capital gain.
4. Transactions Can Be Structured in Four Different Ways.
As needs vary depending on circumstances, real estate investors generally use five different kinds of 1031 exchanges:
- Delayed exchange, with one property being sold and a subsequent property (or properties) being bought within the 180-day window.
- Simultaneous exchange, with both transactions happening at the same time.
- Delayed reverse exchange, in which the replacement property is acquired before the sale of the original property.
- Delayed build-to-suit exchange, with the proceeds being used to finance a new property built to suit the needs of the investor.
Whatever choice a real estate investor makes, the rules of the 1031 exchange still apply in their entirety.
5. You Are Going to Need Some Help With This.
To ensure everything is done according to the exacting standards of the IRS, you will have to engage the services of a 1031 facilitator or qualified intermediary (QI). Some of the more common mistakes made by investors attempting a 1031 exchange for the first time can easily be avoided with professional assistance. These include compliance with the all-important 45- and 180-day windows, the selection and identification of appropriate properties for exchange, and the handling of funds between transactions.
Taking personal receipt of the proceeds of the original sale is a big no-no and will immediately trigger the capital gains tax liability, even if all the other rules of the 1031 exchange are followed. Instead, use a qualified intermediary to handle the funds on your behalf. (You can find a QI with the assistance of your professional team, or through the Federation of Exchange Accommodators (opens in new tab), who will connect you with a local expert.)
6. This Is Complicated Stuff. Is It Worth It?
Let’s look at an example to illustrate. We’ll consider the case of Tracy, who is looking to sell her $3 million apartment building that she purchased for $1 million. We’re assuming the building has no mortgage, and Tracy is looking at a 20{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} capital gains tax rate.
The sale goes through at $3 million. Tracy’s $2 million profit is taxed at 20{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}, costing $400,000. Tracy also faces a net investment income tax of 3.8{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}, or $76,000 (since the transaction is in excess of $250,000), and depending on Tracy’s state of residency, perhaps an additional state capital gains tax as well. Only seven states have no such state tax; those that have it range from North Dakota’s 2.9{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} all the way up to eight states with rates in excess of 8{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}, and topped by California, at a robust 13.3{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}! Unless Tracy lives in a non-tax state, the decision to cash out entirely will be an expensive one: at least $534,000, and perhaps as much as $742,000, in total taxes.
On the other hand …
Tracy could structure a 1031 exchange to acquire a new property. The proceeds from the $3 million sale are sent directly from escrow to a qualified intermediary. Tracy has 180 days from the finalization of the sale to locate and complete the acquisition of the new investment property.
Tracy has identified three possible acquisitions:
- A shopping center valued at $3 million.
- An apartment building valued at $2 million.
- A multifamily home valued at $1 million.
Tracy can do any of the following within 180 days:
- Buy the shopping center for $3 million and defer all capital gains taxes.
- Buy the shopping center and the apartment building for $5 million total, defer all capital gains taxes on $2 million and take out a loan for $3 million split between the two properties.
- Buy both the apartment building for $2 million and the multifamily home for $1 million and defer capital gains taxes on the total purchase price of $3 million.
Don’t forget about DSTs. Many investors today struggle to find suitable replacement properties. A DST, or Delaware Statutory Trust, is a fractional interest in an institutional quality asset owned passively and is offered by a real estate syndication commonly referred to as a sponsor. The DST assets could range from Class A apartment buildings (usually $100 million assets), to medical buildings, self-storage, RV parks, senior living or even Amazon distribution centers. DSTs can be an excellent solution for those who desire a more “hands-off” type of investment. (See a list of DST properties and a video Masterclass on DSTs at provident1031.com (opens in new tab).)
7. One Last ‘Trick’: The Only Way to Make the Tax Deferrals Permanent.
As I’ve mentioned throughout this piece, the 1031 exchange is a tax-deferral strategy, not a tax-elimination one. Eventually, if you sell an investment property and choose not to reinvest the proceeds through a 1031 exchange, the capital gains tax comes due.
Unless … you die.
Upon your death, the investment property you’re holding receives a stepped-up cost basis to its current market value, and your heirs can choose to sell the property at that price with limited or no capital gains tax exposure. It’s a permanent solution to a permanent problem, but one that figures prominently in the estate planning of many real estate investors if they don’t ever need to cash out of their investment properties.
Daniel C. Goodwin, Provident Wealth Advisors (opens in new tab) and AAG Capital, Inc. (opens in new tab) are not attorneys and do not provide legal advice. Nothing in this article should be construed as legal or tax advice. An investor would always be advised to seek competent legal and tax counsel for his or her own unique situation and state-specific laws. Please visit our website at provident1031.com (opens in new tab).
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Property Price Index (PPI) of non-landed residential properties in the different regions
Source: CPF