A 1031 exchange is any large investor’s secret weapon, but you’ll want to be sure to use it even if you’re just getting started. When buying and selling homes, the IRS always wants its slice of the pie in the form of tax.
Although a 1031 exchange can be tricky to use yourself, by researching the rules and working with an experienced tax accountant, you may be able to keep more of your money invested in your properties and out of the IRS’s hands — and legally. Here’s what you need to know about using a 1031 exchange as a real estate investor.
What is a 1031 exchange?
When you sell a rental property, it’s likely that you’ll realize capital gains. Capital gains are the net profit you receive — or the difference between the amount you paid for the property (plus the cost of any improvements and minus any depreciation) and the amount you’re now selling it for.
If you do realize a profit instead of a loss, the IRS requires you to pay a one-time capital gains tax on this amount. If you’ve owned the property for less than a year, you’ll pay short-term capital gains. For properties you’ve owned for more than a year, you’ll pay long-term capital gains. Each type has a different rate, and you’ll pay more for short-term capital gains, of which the tax rate equals your ordinary income tax rate. Long-term capital gains are 0%, 15% or 20% depending on your taxable income and filing status.
Capital gains tax can really add up — especially if you’re an investor buying and selling multiple properties a year. But thankfully, there’s a tool experienced investors use to avoid this tax and move their profit into another investment property. It’s called a 1031 exchange and prevents you from having to pay taxes on your capital gains. A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code,
How does a 1031 exchange benefit investors?
A 1031 exchange allows investors to shift any profit from the quick (hopefully!) sale of one investment property to the purchase of another to avoid paying the dreaded capital gains (or depreciation recapture!) taxes. Essentially, you’re moving your money from one property to another and in doing so, you avoid paying taxes on it to the IRS.
For example, consider you’re selling your rental property for $200,000. You paid $100,000 on it 10 years ago and have $20,000 in qualifying expenses which include a new roof, repaired sewer pipes and costs associated with the sale. Thus, you’ve realized $80,000 in capital gains. Since you’ve owned the property for more than a year, and are in the income bracket of $40,001-$441,450, you’ll need to pay a 15% tax on these gains — or $12,000. However, if you can successfully use a 1031 exchange you could avoid paying this tax altogether.
Depreciation and the 1031 exchange
Each year, most investors write off the percentage of the cost of an investment property on their taxes — or its depreciation in light of wear and tear. If your property sells for more than its depreciated value, the IRS wants to recapture the depreciation by including it in your taxable income from the sale of the property.
This is another benefit of using a 1031 exchange — you may also avoid the large increase in taxable income that depreciation recapture would cause.
How do you use a 1031 exchange for investments?
If you’re considering doing a 1031 exchange for investments, be sure to work with a good CPA or attorney to help you through the process. There are specific criteria your sale and purchase must meet in order to qualify, so it’s best to explore this before you get your eye on purchasing a particular property. Generally, you need to reinvest the money within 180 days and do a “like-kind exchange.”
The definition of a like-kind exchange is relatively vague. You may think the two properties need to be of the same size or type to qualify, but this is not the case. However, the new property must be of greater or equal value to the exchanged property and must be used for business or investment purposes, rather than a personal or primary residency. For example, you could sell your turn-key single-family rental for a run-down four-plex you intend to fix up. The type of property doesn’t matter, but its use does.
The 45-day rule
Although we mentioned that you have 180 days to purchase a property, you only have 45 days from the date of your sale to designate a new property or properties that you’re looking at purchasing to your intermediary — the entity that holds the profit from your sale. You can designate up to three properties (and sometimes more if they qualify) as long as you end up closing on at least one. The intermediary will hold the cash you have received from your sale until you are ready to put it toward another purchase, so the money never hits your bank account.
The 180-day rule
The 180-day rule means that you must actually close on the new property prior to 180 days from the date of your sale. But beware, paying off debt on your initial property doesn’t mean it’s not counted as a capital gain. For example, if you have a mortgage of $100,000 remaining on the old property, but the mortgage on the new property is only $90,000, you still have a gain of $10,000 and it will be taxed.
You can use a 1031 an unlimited number of times as long as your sale and purchase fit all the qualifications. By using the 1031 exchange, you can continue to defer your capital gains taxes indefinitely while building your investment portfolio.
Bottom line: The 1031 exchange is an investor’s best friend
By using the 1031 exchange and streamlining your property management process, you can continue to defer your capital taxes indefinitely. Continue rolling over your profits to invest in more properties and scale your portfolio — all while keeping more money in your pocket (or in this case, in equity).