What Good is a 1031 Exchange?
If you own real estate investment property, you have probably heard the term 1031 exchange at least once, but until you are considering upgrading or selling your property, you might not really know what it means or when you might benefit from it.
What is a 1031 Exchange?
The 1031 Exchange is an incredible tax savings tool for real estate investors. It’s designed to motivate real estate investors to keep expending capital into the real estate market; which economists believe helps our overall economy grow and expand. The 1031 Exchange is part of a group of laws generally known as the “like-kind” exchange rules. These tax incentives have recently been curtailed since the passing of the Tax Cuts and Jobs Act of 2017; but luckily for many of our clients, the like-kind exchange rules still apply to real estate transactions.
Why Does That Matter?
Instead of taking the traditional path to selling an investment property (and paying federal income taxes on the gains), an investor can complete a “1031 exchange” on a property sale and subsequently reinvest the proceeds into a new property – and the best part? Pay NO TAX currently. The 1031 exchange tax rules allow an investor to defer all the federal income taxes until a later date. Here’s an example:
Let’s say you sell investment property for $450,000 with no basis (meaning about $110,000 in tax liability) and you paid $50,000 in selling and closing costs. That means you can only invest $250,000 in a new property:
$450,000 Sale Proceeds
-(50,000) Less Selling Expenses
=$400,000 Gain on Sale
$400,000 Gain on Sale
-(110,000) Federal Tax Liability
=$240,000 Net Cash Flows
If you assume a 25% down payment requirement (and new financing) the size of your new real estate investment would be limited to $960k. Not too bad, right?
But what if you did a 1031 exchange instead?
Without paying any federal income taxes, you will have the full $400,000 gain to invest in a new property. If you had the same down payment requirement of 25%, that means you could acquire a new property worth $1.6m – or $640,000 more in value – that’s over 50% more capital expended into the market place – quite a difference! Yes – deferring the tax is important (after all who wants to pay tax?) but eventually, you will pay tax when you finally liquidate your real-estate holdings. (Or you can hold the property and pass it on to your heirs with a step-up in basis and potentially pay no tax on the gains.)
But – more important than tax deferral is the bigger size of your next real estate deal – with real estate values increasing about 10% over the past two years, the extra appreciation in value on the $1.6mm deal is worth an additional $64,000 in your pocket vs. the $960k purchase. Now that’s real value.
How Does it Work?
To qualify for a 1031 exchange, the property must be “like-kind” – which is essentially the nature or character of the property and not its quality or grade. Personal property is not eligible.
The time frames are also very specific and strict. After you have closed the sale on the property you are giving up, any potential replacement properties must be formally identified within 45 calendar days (this is known as the Identification Period). Closing must occur on the replacement property/properties within 180 days of the initial sale.
You are required to utilize an exchange facilitator to hold the funds between the sale of the old property that the purchase of the new property. Exchange facilitator fees typically range from $1k-$3k per property involved in the exchange. A reverse exchange is also an option – in that case, you buy the new property before you sell the old property. (Exchange facilitator fees can be significantly higher for reverse exchanges.)
This is, of course, simplified and if you are considering a 1031 exchange it is best to speak with a tax professional first to make sure you understand your options and take all the right steps. We’ve seen investors attempt to complete 1031 exchanges without proper tax advice only to later find out they had unexpected taxable boot or failed the timing tests and ended up paying federal income taxes on the gains. If you receive any cash distributions, tenant deposit allocations, rent prorations, or other benefits through the exchange transaction, you may end up with unintended taxable boot. So, if a 1031 exchange is in the cards for you, let’s chat.