The dreaded capital gains tax. Just hearing those words strikes fear into the heart of many investors. You work hard to sell a property or finally profit on an investment and Uncle Sam swoops in for his cut. It’s unfortunate, but you can’t avoid it.
… Or can you?
Well, I’d like to introduce you to a little something called the 1031 Exchange. Many savvy investors use this to multiply their returns and defer capital gains tax on the sale of their real estate investments indefinitely.
The 1031 Exchange is named because of where it sits in the IRS tax code (Section 1031) and it states that a taxpayer may defer recognition of capital gains and related Federal income tax liability on the exchange of certain types of property, including real estate1. What that means in simple terms is that capital gains taxes are only paid upon the sale of a property, without an exchange, otherwise these taxes are deferred.
Rules of the Exchange
Of course, there are specific rules concerning this exchange, and I would recommend having a professional assist you in setting it up. You definitely want to make sure everything is done in compliance. What are some of these rules? Well, there’s a lot, but here are the major ones:
- The properties must be of like-kind, in this case, real estate for real estate. For example, you can exchange a single family home for a multi-family property or commercial property. You can’t exchange it for a car. You can exchange for multiple properties as well.
- It must be for investment purposes and not for a quick turnaround. The 1031 isn't intended for house “flippers.”
- The replacement property needs to be of equal or greater value.
- You have 45 days after you sell your property to identify your new property/properties. You can identify up to three properties in writing and you have to end up purchasing one or more of them.
- You have to purchase the exchange property within 180 days.
- An intermediary has to help with this exchange meaning that all the funds need to go through a neutral party (that's why I mentioned it should be done with professional help.)
If you break any of these rules, your sale will trigger the owing of capital gains taxes and the deferment will not take place. If you manage to follow all the rules, though, you can continue to sell and exchange indefinitely and defer those taxes until you die.
I tend to visualize better with examples, so here’s a simplified example:
In 2014, Dr. Jonas purchased a 12 unit apartment building for $1.2 million dollars in a rapidly improving part of town. He renovated the units for $100,000 and was able to demand higher rents, thereby significantly increasing the property's net operating income.
Three years later, he was able to sell the building for $2.3 million dollars. Had he simply sold this property, he would have had to pay taxes on the $1 million dollar gain (2.3 million – 1.2 million purchase – $100,000 expense).
Instead, Dr. Jonas uses a 1031 Exchange and the proceeds to purchase a 20 unit building where he could repeat the same cycle of improve/sell and defer the taxes until he sells in the future. However, Dr. Jonas has decided to keep this building, live off the cash flow, and give it to his children when he passes on, deferring taxes indefinitely.
Sounds like a Good Deal, Doesn’t It?
“But if I do that,” I hear you say, “won’t my children inherit all those taxes?” That’s a valid concern, but not to worry.
See, the current laws allow your heirs to receive the property at a “stepped up” basis, meaning that your heirs do not “inherit” your tax burden. None of the taxes that you deferred get passed on to your children. Pretty amazing, huh? The only consideration is that estate taxes may come into play if your estate is greater than $5 million. This situation would fall squarely into the category of a “good problem to have.”
This was just a brief introduction to the 1031 exchange, but it really highlights just one of the many tax benefits that come along with real estate investing. Used wisely, the 1031 exchange can help tremendously, not only with your own wealth creation but that of your heirs as well.
It can get quite complicated depending on your exact transaction so consulting with an experienced professional is critical.
Have you used a 1031 exchange before? Any other consideration that need to be made?