How Savvy Investors Use A 1031 Exchange To Defer Capital Gains and Build Wealth
Before putting a real estate property up for sale or deciding to purchase another, it is worthwhile to understand the 1031 tax-deferred exchange. Many real estate investors use this tax practice to defer tax payments and acquire more valuable properties to grow their wealth and increase net worth.
Like everything else with the law, 1031 exchanges have several clauses that guide how they work. By properly understanding the applicable 1031 exchange rules, you’ll avoid any wrong moves that could make you miss out on substantial tax gains.
This article will explore crucial 1031 exchange rules and show you how to avoid common pitfalls that lead to losses for novice investors.
What is a 1031 Exchange?
The 1031 exchange is a legislative clause that allows real estate owners to defer capital gains tax liability during property sales by swapping one investment property for another. It is also called a like-kind exchange or a Starker.
This means a real estate investor can postpone tax payments on a sale by simply using its proceeds to purchase a similar property.
Let’s break this down.
Say a real estate investor makes a $100,000 profit on the sale of rental property. Ordinarily, this profit should be taxed. However, if the investor uses the proceeds from this sale to acquire a property of like-kind, then the real estate investor has no tax or limited tax due on the profit at the time of the exchange.
The next question for many investors is, what does like-kind mean?
Like-kind property can be anything as long as it is not a property for personal use, that is, the investor’s primary residence.
This means you can use the proceeds from the sale of a rental home to acquire raw land, industrial property, or even a storage facility. You can even exchange one business for another, as long as you stay within the stipulations of the law.
According to the IRC, “Both properties must be similar enough to qualify as ‘like-kind.’ Like-kind property is property of the same nature, character, or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like-kind to land.”
Other things you should know about like-kind property include:
Even better, there’s no limit to how many times you can rollover the gain from real estate sales as a 1031 exchange.
Also, if the investor passes away, their heirs may not be required to pay any capital taxes. Instead, the property automatically adopts fair market value and becomes tax-free.
In Class 1 of Master The 1031 Exchange, Daniel Goodwin specifically covers Section 1.1031 of the IRS Revenue Code.
You can register here for the online course. Take it at your own pace. Each lesson is 10 to 13 minutes long and power-packed to help you learn and master the 1031 Exchange and The Delaware Statutory Trust.
Tax Implications of a 1031 Exchange
In some cases, the new property might cost less than the amount realized from the previous real estate sale. When this happens, the intermediary will refund the leftover cash at the end of 180 days. The cash leftover is also called “boot.” The IRS taxes it as partial sales proceeds from the relinquished property.
Something to note here is that boot goes beyond the monetary value of the newly acquired property—if its equity or debt falls below the requirement, the difference in amounts can also be taxed.
Here’s what I mean.
Let’s say you sold your industrial storage facility for $100 million, and you acquired a new property for $80 million. The $20 million difference qualifies as “boot,” and you will pay capital gains tax on the amount.
Many newer investors fall into the trap of not considering loans when doing a 1031 exchange. A mortgage and other loans on both properties can affect your cash boot, making you eligible for tax payments even if you didn’t receive a refund.
How does this work?
Say your mortgage on the relinquished property is $250,000 and the mortgage loan on the new property is $100,000. The difference between both amounts qualifies as a “cash boot” and is subject to taxes.
Delayed Exchange and Timing Rules of a 1031 Exchange
The ideal situation for a 1031 exchange is closing the sale on your current property at the same time as buying another. Simultaneous exchanges were the original idea behind 1031 property exchanges. But, unfortunately, the real estate world is far from ideal—it can take a long time to find someone who has the exact property you want and wants the property you have (think trade by barter here).
Fortunately, there are timing rules that come to play here, so you do not miss out on a 1031 exchange.
When there’s a delayed exchange, a qualified intermediary (QI or middleman) can hold the cash and purchase the ideal replacement property when it’s available in the market.
Suppose a taxpayer makes a real estate sale of $300,000, but there’s a delay in the exchange process. Based on relevant exchange rules, a go-between can hold the funds while they work on identifying potential replacement properties.
Many 1031 exchanges are third-party exchanges facilitated by qualified intermediaries. According to the IRC, you must contact a QI before wrapping up the sale of your property. The added advantage is that intermediaries double-check your sales process to ensure it complies with the tax laws.
A qualified intermediary cannot be your real estate agent. It also cannot be a relative or a person related to your real estate agent.
Next, we will consider an overview of the delayed exchange and timing rules that you will want to ensure that you are familiar with.
6 Reasons To Use A 1031 Exchange
The immediate benefit of opting for a 1031 exchange is tax deferral until a later date. So, let’s dive into when exactly a 1031 exchange is a good idea.
Many investors will opt for the exchange if they fall into one of the following categories.
1. You are seeking a property that has a better return prospect.
A 1031 exchange frees up more capital which means you can acquire a replacement property at a significantly higher value. By trading up for higher-value properties, you’ll be able to build your wealth and hit investment goals quickly.
For example, let’s say you bought a piece of real estate for $500,000 and sold it for $1,500,000. Now, you have capital gain taxes worth $150,000. Instead of paying off these taxes, you can use the proceeds from the sale to acquire a new property worth $500,000, which guarantees higher returns and more cash flow.
2. You are interested in diversifying your assets.
The 1031 real estate exchange allows you to benefit from Delaware Statutory Trusts (DST) for asset diversification. Introduced in 2002, DST allows real estate investors to crowdfund and collectively own fractional interests in the holdings and assets of the trust.
Delaware Statutory Trust has several offerings across different asset classes and geographic locations. This means you can spread your investments and get more returns. For instance, if you earn $300,000 from a property sale, you can invest into a diverse DST portfolio consisting of debt-free storage facilities, a multifamily apartment, a student housing facility, and an office building.
3. You are looking to consolidate several properties into one property.
By consolidating a few of your properties into one, you’ll be able to form a more extensive real estate holding by acquiring just one property but with a promise of much higher returns.
For example, you can use the gains from the sale of two storage facilities to acquire a single student housing facility or apartment building located in a choice area.
4. Eases up real estate management
1031 exchanges are among the best ways to reduce real estate management costs on multiple properties and relieve the stress associated with maintaining several assets simultaneously. You can replace high-maintenance properties with apartment buildings or storage facilities that do not require intensive management or costly maintenance fees.
By utilizing a 1031 exchange, you can delay capital gain taxes and have more money to invest in a high-value property.
5. Increases your purchasing power
One way to grow your wealth as a real estate investor is to acquire high-value properties that promise higher returns. While you might not have the funds to acquire these types of properties right away, you can work your way there by purchasing lower-cost properties with future sales opportunities.
6. Increases your income and cash flow
A subtle benefit of a 1031 tax-deferred exchange is that it allows you to swap low-ROI properties with more promising alternatives.
For example, an investor who owns a vacant parcel of land that generates no cash flow or depreciation benefits can exchange this property for a more viable commercial building.
How To Do A 1031 Exchange
Undertaking 1031 exchanges can be complex, and this is why you need to speak with a tax lawyer first. Nevertheless, it pays for you to know how the process works in a broader sense so you’d be on the same page with your lawyer.
Here are some basics about how 1031 exchanges typically work:
Step 1: Choose the property you’d like to put up for sale.
Remember, this should be industrial real estate and not your personal residence.
Step 2: Identify the potential replacement properties.
The ideal replacement property must be of “like-kind“; that is, having the exact nature, class, and character as the property on sale.
Step 3: Choose a Qualified Intermediary
The QI holds the money from escrow until you make a property exchange. Remember, the exchange facilitator cannot be your attorney, accountant, real estate agent, or anyone related to you.
Step 4: If you’d like to withhold some of the profit from the sale, you need to inform your Qualified Intermediary on-time.
However, note that you will have to pay taxes on the withheld amount.
Step 5: Remember the applicable timeframe rules for 1031 property exchanges.
That is precisely the 45-day rule and 180-rule. See above for explanations for these rules.
Step 6: Submit IRS Form 8824
Submit IRS Form 8824 with your tax return to tell the IRS about the 1031 exchange and applicable transactions.
Restrictions on 1031 Exchanges
Expectedly, many real estate investors want to leverage 1031 exchanges for great returns. However, before jumping on this train, you should know certain IRC restrictions on swapping properties.
First, you must be the sole legal owner of the property in question. For example, if you own a share in an EIT or an LLC, you cannot apply for 1031 exchanges.
In addition, you cannot use 1031 exchanges for your personal property; it only applies to industrial estates. However, suppose you convert your personal estate like a vacation home into a rental property. In that case, you can claim a 1031 exchange as long as you rented out the residence 6–12 months before putting it on sale.
1031 property exchanges provide significant tax advantages, especially for high-value investors. By opting for tax-deferral moves, you can grow your wealth and assets with minimal financial liabilities.
However, to fully benefit from the exchange code, you must understand how it works and act within the law’s provisions. For example, a 1031 exchange isn’t an excuse for flipping properties, as you have to hold the property for a specific period (usually 12–24 months) before putting it up for sale.
If you plan to build long-term real estate wealth through 1031 exchanges, then it’s a good time to sign up for my masterclass: Master The 1031 Exchange with Daniel Goodwin. In this class, you will receive first-hand knowledge on property exchange complexities and how to navigate them for exceptional real estate returns.