Does tax-free real estate investing sound good to you? It certainly seems like a great way to build wealth and create your own real estate empire! It is completely possible to avoid taxes with 1031 exchanges. It’s completely legal, not too hard once you have a firm grasp of the rules, and it can help you grow your investments and save money on taxes. We’ll walk you through the definition of a 1031 exchange, who they benefit, the downsides of the process, and then the process itself. It should give you a good idea of whether a 1031 exchange could benefit you in the future!
What is a 1031 exchange?
A 1031 exchange is when you go through a set of steps to essentially exchange investment properties in the eyes of the IRS, instead of the regular selling and buying process in which you’d have to pay taxes on the profit from the sale of the investment property. Named after section 1031 of the United States’ IRS tax code, 1031 exchanges can apply to real estate land or even buildings, airplanes, boats, livestock, and more.
A 1031 exchange defers the tax payments for capital gains tax, depreciation, state and local taxes, and possibly others, depending on your tax bracket. Completing the 1031 exchange and following all its requirements will allow you to keep all the money that you would have normally paid in taxes—provided that you use all the money to purchase another investment property. Technically, the tax is not actually dismissed, but it’s deferred, meaning that depending on future circumstances it may be paid later or it may not.
While you never actually receive the saved money yourself, 1031 exchanges are used for long-term wealth building and they’re very useful for scaling up businesses and increasing property holdings over a period of time.
Who are 1031 exchanges for?
If you own rental properties, you should definitely look into the possibility of 1031 exchanges. If you are happy with all your properties and have no desire to sell, then 1031 exchanges are not for you; but if you’re selling and reinvesting in more real estate, this rule can benefit you greatly.
Use 1031 Exchanges to Scale Up
You might want to do a 1031 exchange if you want to change rental type or scale up in size with your investments: i.e. a condo to a single family home, or a couple houses to an apartment complex or commercial location. Or perhaps you’re packing up and moving across the country, and you want to exchange your current rental properties for ones that are closer to your new home. Maybe you’re not impressed with the amount of cash flow or level of management that’s necessary with one or more of your current properties and you’d like to exchange them for something more lucrative or more low-maintenance.
Whatever your reason, it’s imperative that you’re exchanging your former investment property for another investment property of equal or great value. There are a few more catches that we’ll get to in the next section.
What’s the catch?
- Deferred, not cancelled—Like we said in the definition of the 1031 exchange, your taxes are deferred, not cancelled. Eventually, if you sell a property and you don’t do the 1031 exchange, then you’ll have to pay the taxes.
- Doesn’t apply to flipping or personal property—The intent needs to be as a rental property, so if you are flipping properties for resale, this does not apply to you—they need to be purchased with the intent of long term rentals; the general time period that you should hold a property in one of these exchanges is a minimum of 2 years. 1031 exchanges also do not apply to your personal family home, only to investment properties.
- You can’t scale down, only up— If you buy a house for $100,000 and sell for $130,000, the new investment property needs to be at least $130,000 if not more. The new investment can’t exceed 200% of the price of the property you’re selling, either.
- It’s easy to remain stagnant and never make money—If you actually want to benefit from a 1031 exchange you will need a bigger loan or to bring more money in or else you won’t ever make money with 1031 exchanges.
- Limited time period—The time periods in a 1031 exchange are strict and non-negotiable. There are no exceptions. You have 45 days to identify potential new investment properties and 180 days to close on the deal, so you have to move pretty fast. You have a short window so it’s important to jump as soon as you find a deal. There are no exceptions to the time limit (even if the 180th day is a weekend or holiday), and if you exceed the time period without closing, you will have to pay taxes on your gains like normal. Of course, it could be worse, but it will defeat the purpose of trying to get a 1031 exchange.
- No partners allowed—Whether you’re buying and selling through your personal name or your LLC, it’s mandatory that all the properties in the exchange are held by the same taxpayer. This means you can’t buy a big investment property with a partner or group of partners and still get the benefits of the 1031 exchange.
First, get the property that you’re selling under contract with a new buyer. You should probably include the 1031 exchange in the contract.
Then, you’ll need to have a qualified intermediary who will approve the HUD closing statement and hold the money that you’ve deferred in their escrow account until you’re able to reinvest it (remember, you’ll need to do this in 180 days or less!) The intermediary is mandatory and they will charge a fee of somewhere between $500 and $2000 for their services. Don’t worry about the extra cost though—intermediaries can also help guide you through the complex process and answer any questions you might have, and it’s impossible to do a 1031 exchange without them, so they’re worth it.
Before the time limit is up, you’ll have to reinvest the profit from the property you sold into the new and better property. And that’s it! Hopefully the process seems less daunting to you now and you understand the pros and cons of tax-free real estate investing!