The mysterious 1031 exchange…
Something that everyone knows about but almost nobody understands. Well, in today’s article we’re going to understand it! Today we’re going to be digging deep into the 1031 exchange, explaining what it is for those of you who don’t know, and how we can use it effectively in our real estate investing career.
So, what is a 1031 exchange anyway? A 1031 exchange is a swap of investment property for other investment property that allows capital gains taxes to be deferred. The name, although it seems fancy, simply refers to IRS code Section 1031 which lays out the rules for this. The 1031 is just one of many tax advantages that real estate provides. You can learn more about real estate tax advantages in our past videos talking about the 5 Benefits of Real Estate Investing and Comparing the 401K vs Real Estate Investing.
Now let’s get into some more specifics of the 1031 exchange!
First, the properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred. By deferred, I mean you will not have to pay taxes on the proceeds of your sale but you will still incur a tax liability which means you will have to pay later when you sell and don’t do a 1031. The rules around this are quite loose though and you can generally exchange any type of investment real estate for another, regardless if they have the same amount of units, are in the same class of real estate (residential or commercial), or are improved land or just raw land. Just make sure they’re both in the United States!
Second, although the word “exchange” may seem like you must be trading a property with someone else, it’s not meant literally. Most 1031 exchanges are “delayed” exchanges that involve a third-party. In order to do a delayed exchange, the proceeds from the sale of your current property must be held by the third party, usually an escrow company, and used to directly buy the property you are buying next or commonly called “1031ing into”. Let me be clear, you never actually get to see the proceeds of the sale in your own bank account. They must be held and managed by a third party or else you are not compliant with the 1031 exchange rules.
Two additional things to be aware of during your 1031 exchange in addition to using a third party are the 45 “identify” and 180 day “close” rules. The 45 day “identify” rule says you must identify, in writing, the property or properties you want to 1031 into within 45 days of the sale of your current property. Then, the 180 day “close” rule says you must close on such identified property or properties within 180 days of your current property’s sale.
If you have any additional money left over from the purchase of new property or properties, it will be paid back to you, although you will have to pay capital gains tax on it. You must also maintain the same level of liability or leverage if you want to avoid paying capital gains tax. If your liability, or amount you have mortgaged decreases, you will owe capital gains on that spread just like any cash back. You will always want to maintain the same amount of cash, or equity in the new properties and the same amount of leverage. If used correctly, there is no limit on how many times or how frequently you can do 1031 exchanges.
Now let’s run through an example of how to use the 1031 exchange properly and effectively!
Say you bought said property for $800,000 with a $100,000 down payment and it is now worth $1,000,000. This $1,000,000 property has 30% equity ($300,000) and 70% loan ($700,000). If you sold this property outright, you would owe capital gains tax on your $200,000 appreciation gain.
If we used a 1031 exchange and rolled the proceeds over to another property or properties, we could defer paying the capital gains tax on that $200,000 appreciation gain. But, let’s make sure we follow the rules! Remember:
- We must buy something that is like-kind, so we can’t go and buy a bunch of livestock with this money or something, we’d have to look for something in the class of real estate to 1031 into.
- We must get a 1031 approved third party involved to handle the funds. We never actually get to touch any of this money, it is only a transfer through the third party.
- We must identify a new purchase property within 45 days and close on it within 180 days.
- We must maintain the same amount of equity ($300,000) and liability ($700,000 in mortgages) into the new properties to avoid paying capital gains tax.
If we do all of this correctly, we will then be able to completely defer our tax liability on the $200,000 we would normally owe, and redeploy that into another more profitable property or disperse it into multiple properties that add up to a much higher return on investment. Dividing our $300,000 equity into 3 different properties, with $100,000 in equity in each and $233,333 in leverage allows us to perfectly redeploy equity in an efficient manner to increase cash flows, all while avoiding capital gains taxes. We don’t want equity just sitting around in our properties, we want our little green soldiers out there fighting hard for us! The 1031 exchange is a great way to do that.
The icing on the cake for this strategy is that these tax deferments are forgiven at death. This can help create multigenerational wealth and provide your family a secure financial future.
Needless to say, the 1031 exchange is an extremely powerful tool in real estate investing however with great power comes great responsibility. You really don’t want to mess this up. That’s why we highly encourage hiring a real estate tax professional to execute a 1031 exchange properly.
Gary Keller, founder of Keller-Williams, the largest real estate company in the world says, “In the end it’s the tax-deferred 1031 exchange that gets massive use by millionaire real estate Investors.” Trust me, Gary knows a thing or two about real estate!
Thanks for reading the blog! Thank yourself for bettering your future and real estate education as well! Keep up the good work reading, learning, and taking action! Now go start investing!