If you have a property you’re looking to sell, should you sell it? Or should you do a 1031 exchange?
A 1031 exchange is a tax exempt exchange where you can roll into the capital gains property and defer the capital gains tax. The capital gains tax is the levy on the profit from an investment that is incurred when the investment is sold.
How does a 1031 exchange really work?
A 1031 in the tax code allows you to take the capital gains from a property you sell and invest that money into a new property of “like-kind” (A like-kind exchange is a tax-deferred transaction that allows for the disposal of an asset and the acquisition of another similar asset without generating a capital gains tax liability from the sale of the first asset. The term like-kind property refers to two real estate assets of a similar nature regardless of grade or quality that can be exchanged without incurring any tax liability. The Internal Revenue Code (IRC) defines a like-kind property as any held for investment, trade, or business purposes under Section 1031, making them a 1031 exchange. This means both properties involved in the exchange must be for business or investment purposes. Personal residences, therefore, do not qualify as like-kind properties).
Qualified third party groups hold the funds. They will hold them for you for a period of time until you can identify a new property and prepare to close on a new one.
In general, when it comes to deferring capital gains; (Tax-deferred status refers to investment earnings—such as interest, dividends, or capital gains—that accumulate tax-free until the investor takes constructive receipt of the profits), that’s the reason people do 1031 exchanges.
Let’s say you have a rental property you bought for $500,000. It’s worth $1 million right now.
You got $500,000 in gains. You’ve got all this money and would love to sell it. But if you did, you would have to pay all the taxes on it. A 1031 exchange allows you to take that money and defer it to a larger deal. You’ll have up to 45 days to identify a property. You can identify up to three new properties and then you’ll have six months to close. These timelines can be very tight and if you don’t make them, the money goes to capital gain and you have to pay the taxes. You’ll need a plan of attack and be able to get it done if that’s your goal.
What if I Sell the Property?
What happens if you sell this property? What if you don’t want to bother with a 1031 exchange? You can totally do that! There’s nothing wrong with that:
Pretend you have a $2 million multifamily apartment. You have $1 million in gains. There are long term gains; (the gain may be short-term - one year or less or long-term - more than one year and must be claimed on income taxes). When you sell that property, you get taxed. For your state and your federal taxes, let’s say your rate is 25%. That means you will have net $750,000 on that $1 million and you’ll pay $250,000 in taxes,
That’s a lot of money! If you had the option to defer those taxes, I think it’s really important; it makes so much more sense to do a 1031 exchange into the next property. There are, however, some considerations to be made. If you can’t find another property, you might have some trouble with this option. Especially in this market where things are so competitive! Another consideration is maybe you have to sell right now. Maybe your partners or family members don’t want to be involved in the next deal. If there’s enough equity in the deal, you could potentially 1031 part of it or cash people out.
One approach is to try the 1031. Get it set up, pay the fee, do it. Then you look around and see what you can find. If you’re having trouble finding a replacement property, this is something you can look at.
Other 1031 Considerations
What are some other considerations when it comes to a 1031 exchange? First, when you are going into the next property, there is a challenge that might come up. The person who’s selling a property will know you are at a 1031 exchange and you’re on a tight timeline.
Why is that important? It gives you a pretty significant disadvantage; They know if the deal doesn’t close you’ll be penalized because this is one of the properties you’ve identified, they can come back and say they won’t work with you, they want you to pay additional charges,
They won’t have any concessions with the house or the property. People can really take advantage, they know that you have to close this sooner or else you’ll have a bigger tax bill.
There is another way to do it!
You can identify the new property first before you sell the current property.
What does that actually look like? You have the new property and get it under contract. Then you’ll say you have some extensions built in. Then you’ll say you’re going to make additional money guaranteed or that you will make it non-refundable after a certain period of time (maybe another 30 days). The person you’re buying from knows the property will close. They’re not concerned. This tactic allows you to identify the new property first and then you can list and sell it. You’re going in at this already agreed upon price. It’s challenging, but it is a safer way to do a 1031.
There other considerations such as an “Investment Sales Trust” too lengthy to discuss here.
The issue really is timing. You can use a 1031 and then try to figure out where you’ll put it. You can use a 1031 and then try to figure out where you’ll put it.
In general, when it comes to 1030, try to . If you can just continue to defer taxes, it’s going be much better than every time you sell a property.