When buying and selling real estate, taxes can eat up a large section of your capital gains. This can be devastating to someone who is just getting started in the business. While you may think this is inevitable, there is a little secret that long-time investors hold near and dear—the 1031 Exchange.
What is the 1031 Exchange?
Before we get into the simplified explanation of the 1031 Exchange, let’s take a look at the actual IRS’s mention of the process.
According to Title 26, Section 1031 of the Internal Revenue Code, “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Sounds fancy, but what does it mean?
Basically, it means that if you are selling a property to immediately purchase another property, then you may be exempt from taxes on the sale. You don’t have to worry about swapping the property for the exact same type. When they refer to “like-kind” they are simply referring to a real estate for real estate transaction. So, if you’re looking to sell your two-bedroom to upgrade to a three-bedroom, don’t worry. You could still qualify for a 1031 Exchange.
Limitations on the 1031
The tax man likes his money, so obviously there would be a restriction on how many times you can defer or exempt your profit from taxes, right? Actually, wrong. When it comes to the 1031 Exchange, there is no limitation on how many times or how often you do a 1031 Exchange. Even if you begin to roll into a rather large profit, as long as you are continuing to utilize transactions that fall under the 1031 Exchange the profit will not be taxed.
When you sell for cash is when a tax will be assessed—often as a long-term capital gain tax.
Of course, as with all government benefits, there are always some restrictions. The property can only be used for investment purposes—meaning, it cannot be used as a personal residence. Exchanges must be completed within certain deadlines and time frames. The properties must also be located in the US. Sorry, no foreign soil qualifies here.
Other stipulations include that the property (or properties) you are exchanging it for be of equal or greater value than the original property. Now, one loop hole is that you can purchase multiple properties as long as the combined total value equates or surpasses the original property.
What to Use the 1031 Exchange For
When you use the 1031 Exchange, you are essentially growing your investment portfolio with the help of the US government. Think of it like a partnership. A very silent, yet beneficial, partnership. The 1031 Exchange allows you to continue to grow your value—trading up repeatedly without suffering the loss of capital gains taxes. Instead of paying that percentage to the tax man, you shift it into the next property as positive equity.
As this process allows you to make more money on the next property, when you do finally sell the property for cash the tax man will get a larger cut than if they simply took a little here and a little there. Hence why they allow this type of exchange.
Some Taxes Necessary
Now, it is possible to use only a portion of your profit in a 1031 Exchange. This is often referred to as a “boot.” As an example, if you sell your first property for $100,000 but purchase another with that money for only $90,000, then you will be required to pay capital gains taxes on that remaining $10,000 balance.
This is where things get hairy. When you opt to utilize a 1031 Exchange, you have a very limited window in which to carry out the transaction. According to the IRS, you have exactly 45 days to select a property you will be closing on or you stand to lose the 1031 Exchange benefit of tax deferral. So, to recap, you have exactly 45 days from the date you close on your sale to identify a property to purchase.
Understanding that real estate sales sometimes fall through, the IRS does allow you to “officially identify” three properties. This gives you two back-ups in case your initial choice falls through. However, if all three properties fall through, you will lose out on the 1031 Exchange benefit.
The next time limit placed on your transaction is the closing window. You have 180 days to close on the new property. This 180-day window begins the countdown the moment you sell the relinquished property—not at the end of the 45-day identification period. This means you have 180 days from the first closing to have the property title in your name at the second closing.
The biggest catch? Within that 180-day period, the money from the initial sale can never be under your control. This means it cannot touch your bank account or be under the management of you. The entire process has to be managed by a qualified intermediary. Make sure to select an experienced company to act as your intermediary in this situation as any violation of any of the stipulations can disqualify you from the 1031 Exchange benefits. According to the Internal Revenue Code’s Section 1031, a qualified intermediary cannot be you, your agent, your broker, your spouse, your family member, your investment banker, your employee, your business associate, or anyone who has had one of these roles in the past two years.
Selecting this route, while time-constraining, can be exceptionally beneficial as it allows you to increase your rental value, your property value, and your profit without suffering any of the tax penalties that you would normally face. Utilizing the 1031 Exchange method is a great way to grow your investment portfolio and set yourself up for a successful real estate investment career.