Owning that first rental property is a huge milestone for investors. It lets you dip your toe into the market, gain experience in property management, and build confidence in your judgement. But for ambitious landlords, the first property is marks just one step on a larger journey toward passive income and financial independence.
But it’s not always easy to expand your portfolio. Most investors, face two main obstacles: capital and capital gains. The former is simply a question of where you are going to get the money for your second (and third, and fourth) properties? The latter is a question of, how much of your wealth will you be able to hold onto in the face of capital gains taxes that can run as high as 40%?
Happily, there’s a solution that addresses both those concerns at the same time. A semi-obscure tax provision called the 1031 exchange allows investors to defer that punishing capital gains tax liability, and reinvest every penny of their hard-earned profit in their next investment. But like a lot of the tax code, it comes with a list of potentially confusing rules attached. Let’s go over some of the details of the 1031 exchange, and figure out if and when it’s right for you.
What Is a 1031 Exchange?
A 1031 exchange allows you to essentially trade or “exchange” one investment property for another investment property of similar or greater value, without paying capital gains taxes on the profits from the sold property.
Let’s say you bought a property at $100,000, and it’s now worth $300,000. If you sold that property without using a 1031 exchange, you could lose 40% of that $200,000 profit, or $80,000, to Uncle Sam. That could seriously hamper your efforts to use that money to upgrade your portfolio: a 20% down payment of $120,000 gets you a much less valuable property than a 20% down payment of $200,000.
And yes, you can still take rental property tax deductions before, during, or after doing a 1031 exchange.
Who Qualifies for 1031 Exchanges?
By using a 1031 exchange means you can defer your capital gains taxes, and invest that entire $200,000 of profit. But as with every legal loophole, some restrictions apply. If you can’t comply with at least three out of the next four criteria, you probably aren’t eligible for a 1031 exchange.
1031 Exchanges: For Real Estate Investors, Not Homeowners
A 1031 exchange is a tool that’s meant for investors. The bad news: in most cases, you can’t do a 1031 exchange on your primary residence.
The good news? You don’t need to. The IRS already offers a generous capital gains exemption for your primary residence!
Property of Equal or Greater Value
You can’t use a 1031 exchange to defer your capital gains tax liability if you’re planning to simply sell off your investment property and pocket the profits. This is a tool for investors who are trying to level up their portfolio. Most commonly, investors who use a 1031 exchange take the entire proceeds from their initial sale, and put it down as a 20% down payment on a larger investment property.
1031 Exchange Must Be “Like-Kind”
The 1031 exchange has a “like kind” rule, which means the property being relinquished has to be similar to the property being purchased. But this rule is very forgiving; as long as you’re buying and selling investment property, you’re very likely to meet the “like kind” requirements.
The only circumstances where you might run into trouble is if you were trying to use a 1031 exchange to sell investment property and reinvest the money in, say, stocks.
1031 Exchange Timeline
Since this is supposed to be a trade of properties, there are strict time limits on how long you have to execute your 1031 exchange.
You’ll have a 45 day “identification period” after you sell your initial property to identify subsequent investment properties. That means you’ll likely want to start looking at potential properties well before you close on that initial sale.
If that sounds daunting, there’s also some good news here. Since finding the perfect exchange candidate while you’re on the clock can be a challenge, the rules of the 1031 exchange allow you to identify up to three replacement properties, to give yourself a little wiggle room. You don’t have to buy all three of the properties, but you do have to buy at least one. And if you buy multiple replacement properties, the total value of them must be equal or greater than the sale price of the initial property.
One last time-related rule: you must complete the sale of your replacement property within 180 days of selling the initial property. Even one day longer and you risk losing all the tax benefits of the 1031.
You’re Eligible. Does It Make Sense for You?
Just because you meet all the requirements for a 1031 exchange doesn’t necessarily mean that it’s in your best interests. Here are some important factors to consider.
What Is Your Tax Burden?
Some investors are so focused on using a 1031 exchange to upgrade their holdings that they haven’t even bothered to calculate their tax liability.
Let’s say you’re selling a plot of land. Since you can’t claim depreciation on land— only on structures that actually wear out, decay, or fall apart— you won’t have to worry about depreciation recapture at the time of sale, which is one of the biggest factors that can inflate an investor’s tax bill. In this case, it may not even make sense for you to pursue a 1031 exchange over a straightforward sale.
Similarly, let’s say you’re selling your rental property in a state like New Hampshire, Florida, Alaska, or Tennessee. Those states, among others, don’t collect capital gains taxes, so you wouldn’t be deferring anything.
Make sure you figure out your exact tax liability before you consider strategies to defer it. It might not be that bad!
Do You Need Cash?
To defer all your capital gains taxes, you’ll have to invest the entire proceeds from your property sale. While a partial exchange is an option, you’ll have to pay taxes on however much you cash out, which can radically skew the cost/benefit equation. If you might need liquidity in the near future, a 1031 might be a great option, since you would never actually hold any cash from the sale.
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Do You Have Actual Gains to Defer?
This may sound obvious, but if the property you’re selling hasn’t appreciated since you purchased it, a 1031 exchange is going to have very limited advantages over a straightforward sale. In the same vein, small gains are going to offer small deferral benefits.
Are You a House Flipper?
House flippers are usually ineligible for a 1031, even though they seem to fit all the requirements. After all, a house purchased to be flipped is clearly an investment property.
But a closer reading of the 1031 exchange regulations reveals an inconvenient exception for house flippers; property “held primarily for resale” does not qualify for a 1031 exchange. The regulations also specify that the sold property must have been “used in a trade or business,” i.e. produced income while you owned it.
The 1031 exchange is designed to defer long-term capital gains taxes, not regular income taxes. So the only way that house flippers can use a 1031 is to hold the property for a year, rent it out, and then trade it up.
How Do 1031 Exchanges Work?
Let’s say you’ve decided that a 1031 exchange is right for you, and that you want to do one. Well, the law states that you can’t actually oversee the exchange. Neither can your friends, family members, or even professionals you might pay to help administrate your investments, like property managers, real estate lawyers, or agents.
The actual 1031 exchange will actually be carried out by a qualified intermediary (QI), a company set up for the specific purpose of carrying out 1031s. You, the seller, don’t ever come into possession of the proceeds of the initial sale; that property is sold by the qualified intermediary, who uses the money to buy the replacement property on your behalf, and then transfer the deed to you. From the investor’s perspective, it really is a trade; they relinquish the initial property to the QI, who then gives them the deed to the replacement property.
The qualified intermediary also handles all the tax forms, makes sure the exchange meets IRS guidelines, and can advise you on meeting the many affiliated deadlines so you can definitely secure the tax benefits. You’ll have to pay for these services, but the fees are pretty reasonable; nationally, QI services cost, on average, between $600 and $1,200. That can go up if you’re doing a more complicated reverse exchange, or an exchange involving multiple properties, but in general, it’s a small price to pay for what can be massive benefits.♦
Have you ever considered doing a 1031 exchange? Why or why not?