This is the number one way real estate investors accumulate wealth and that is the 1031 exchange.
The 1031 exchange specifically comes from Section 1031 in the Internal Revenue Code, and it allows real estate investors to defer paying taxes on real estate gains.
This means, you can avoid the biggest expense of them all, which are taxes, and instead use that money to reinvest and make even more money.
So today, we’re going to fully explain what 1031 exchange is, and how you can take advantage of it.
Creating a wealth snowball effect all because you legally took advantage of the 1031 exchange.
This is exactly what wealthy, successful real estate investors do to create wealth, and you should be aware of it.
What is a 1031 Exchange
Now allow us to break down 1031 exchanges. As we mentioned before, 1031 comes from the Internal Revenue Code Section 1031.
The “Exchange” is the defining part. And what it is in reference to is the ‘exchange of properties’.
So basically, the IRS states that when you sell a piece of property and earn a profit from the sale, you can defer paying taxes on that profit if you use the proceeds to buy another property.
This is otherwise known as a “like kind exchange.”
You are exchanging properties that are “like kind” or similar.
The IRS figures that since you are using the profits and proceeds from the real estate sale to acquire another similar property…
…you don’t need to pay taxes on that until you actually stop buying investment properties altogether.
Let’s take a look at an example.
Example of a 1031 Exchange
Let’s say you invest in your first rental property. It can be a single-family home, a multifamily unit, or even a commercial property.
As long as it is a piece of property purchased for investment, or business purposes.
So you bought it for $250,000.
You have tenants occupying the property, paying monthly rent. Everything is great.
Some time goes by, and you come across another property that seems to be a great investment. And perhaps your current property is not as profitable as you hoped.
So you decide to sell your current property with the intention of purchasing the better property you found.
Well, in the appreciated real estate market that we’re in, the current property is now worth $300,000 and sold for that amount.
Normal IRS rules would make you pay capital gains tax on the $50,000 gain on the sale.
But since you are going to use the profits and proceeds to purchase the better property you found, no tax is due.
And this is a 1031 exchange.
What Makes a 1031 Exchange Valuable?
So now, you might be wondering what exactly makes 1031 exchanges really valuable to a real estate investor?
This is a good question because, at first thought, it seems that your profits from a real estate sale are not going to you directly but instead being tied up in another property.
Well, we know one valuable benefit is you can avoid paying capital gains tax but you can also continue to reinvest into newer and better properties.
Which ultimately, should result in more cash flow for you assuming you are buying good investments.
And if you’ve read our real estate depreciation post, you’ll learn how you can use depreciation expense to avoid paying tax on your cash flow as well.
Benefits of 1031 Exchanges
The great part about 1031 exchanges is you’re not just limited to doing this just once.
You can continue to do 1031 exchanges for multiple properties over and over again.
So if you did a 1031 exchange and the property you bought didn’t turn out as great as you’d like, or maybe you realized it wasn’t as lucrative as you expected…
…you can turn around and do another 1031 exchange and avoid any taxes on the sale.
And use otherwise taxed income towards a better investment.
This is how you grow your real estate portfolio and build wealth.
You can sell an underperforming property for a profit and use the proceeds to buy another property.
Or, you could even sell a property that is performing well and has appreciated tremendously in value…
…maybe 40 to 50 percent, and use those proceeds from that sale to buy 2 or 3 more properties and earn cash flow from those assets.
This is exactly what the rich do to grow their wealth and net worth.
They buy a single-family home, sell it after some time and use the profits to buy a multi-family apartment unit or duplex and earn more cash flow from that.
Then that’s sold to buy an even larger asset and earn more cash flow.
All of which is tax-free through a 1031 exchange.
Even better, when used as a long-term strategy, not only can you do a 1031 exchange over and over again to buy bigger and better properties…
…when you die, all of the properties and profits you earn get passed down to your children and family, tax-free.
It’s a powerful way to create generational wealth and legacy.
If you want to build generational wealth, 1031 exchanges are a great, wise strategy to employ.
Do keep in mind that if after doing a 1031 exchange on a property, you decide that you do not want to do another 1031 exchange and decide to sell that property…
…then taxes would be due on all of the real estate gains you had leading up to the sale of that property.
So you can keep deferring the taxes due with 1031 exchanges as many times as you’d like, but if you stop doing 1031 exchanges, and sell your properties, the tax would then be due.
But this is typically not a terrible thing, especially considering the amount of cash flow and wealth you would have accumulated by that point with doing 1031 exchanges.
Rules and Steps to Take For a 1031 Exchange
Hopefully, at this point, you understand the benefits of 1031 exchanges. Now, we want to explain the rules and steps to take to successfully complete a 1031 exchange.
1. Identify the property you want to sell.
An important rule when doing a 1031 exchange is you must identify the like kind property you want to buy no more than 45 days after your current property is sold.
If you’re in real estate already, you know that 45 days is not a long time to find a property but those are the rules.
In addition, you have 180 days or 6 months to actually close on the new property.
So 45 days to find and commit to the new property and 6 months to close. Got it?
If for some reason, you need more than 45 days to find a new property, you have a few options.
One is just paying the capital gains tax which a lot of people do to avoid the stress of finding a property.
Or, you can put your 1031 money in a Delaware Statutory Trust or “DST”.
A DST is a separate legal entity that is combined with other investors’ money for the purpose of buying bigger real estate deals.
You would certainly make more money from finding and funding your own real estate deal.
But, DSTs are an option if you want to avoid capital gains taxes and the 45 days were not enough time for you.
2. Hire a qualified intermediary to facilitate the transaction.
This is probably the most important rule.
A qualified intermediary is an individual or business that agrees to facilitate a 1031 exchange.
And, they do so by holding the funds involved in the transaction until it can be transferred to the seller of the replacement property.
They’re basically a middle man.
The IRS can’t tax you for money that you never touched so this is where the qualified intermediary comes into play.
The qualified intermediary can not be related to either party in the real estate transaction.
The intermediary can include, but is not limited to, an attorney, accountant, investment broker, or real estate broker.
If you’re looking for credible CPAs to help you with this, contact us today.
It is really important to have a qualified intermediary in place before the sale of the property.
If you take possession of any of the funds, even for just a little, that can completely disqualify you from using a 1031 exchange.
3. The replacement property has to be of equal or greater value than the selling property.
This means, you can’t sell the original property for $300,000 and only acquire a $200,000 property for purposes of 1031.
We mean you can, but the difference in value is called “BOOT” and that portion is taxable.
Instead, you need to make sure the like kind or replacement property is equal to or greater than the fair market value of the original property.
There are a few more rules and requirements items to remember.
First, a 1031 exchange must be reported to the IRS. Yes, they are not taxable but the IRS still wants to know about it.
So you would report the 1031 transaction on Form 8824 and include it with your tax return.
If you have a business entity set up for your real estate deals, then 8824 would be included with your business tax return.
Next, remember 1031 exchanges are for investment or business purposes.
They are not to be used for your personal residence. So if you buy a piece of property and then decide to live in it, you can not do a 1031 exchange on that property.
Recap of Steps
1031 exchanges can be very complex transactions so let me recap the steps for you:
- Identify the property you want to sell.
- Hire a qualified intermediary to facilitate the transaction.
- Once the original property is sold, you have 45 days to find a replacement property. Let your qualified intermediary know what property you want to buy.
- Provide your qualified intermediary with the purchase contract of the new property.
Your qualified intermediary will walk you through a lot of these steps by the way.
- Close on the replacement property within 180 days of the sale of the original property.
- File IRS Form 8824 reporting the 1031 exchange. Do this for the tax year in which the original property was sold.
Not so bad, right?
Reverse 1031 Exchanges
We also want you to know about the reverse 1031 exchanges.
In these cases, you identify and buy the replacement property before the original property is sold.
This is totally possible and not entirely uncommon.
The timeline works the exact same but in reverse.
You would have 45 days from the purchase of the replacement property to identify which property you want to sell.
And, have 180 days from the purchase date to complete the sale of the original property.
Again, this is known as a Reverse 1031 Exchange.
1031 Exchange Costs
So lastly, we want you to know about the costs of a 1031 exchange.
In addition to the normal costs associated with buying and selling real estate, like agent commissions and other closing costs, you’ll have to pay a qualified intermediary.
You can expect to reasonably pay anywhere between $800 – $1200 for a qualified intermediary.
Not bad. Qualified intermediaries make most of their money from the interest income they earn on holding your 1031 funds.
An optional but highly recommended cost is to hire a CPA or tax attorney. As mentioned before 1031 exchanges are very complex and impact the way you report your taxes.
And a qualified intermediary is not technically qualified to give you tax advice. So consider the costs to hire a competent CPA or attorney that specializes in 1031 exchanges.
Again, LYFE Accounting has a team of reliable CPAs that you can work with. Get in touch with us today to learn more about our services.
And that’s it! We hope you now have a better understanding of 1031 exchanges.
If you have any questions or comments, please leave them below. We’d love to hear what you think!