If you’ve been around the real estate investment world for a while, you've likely heard about a 1031 Exchange. At its core, it is a powerful wealth building tool for the savvy investor. In its most basic element, it can defer the capital gains taxes for any investor. As a seasoned exchange accommodator, I am going to break down the ins and outs of a 1031 exchange for you into a simple 3 parts series; The Basics of a 1031 Exchange, Rules and Types of Exchanges, and Strategies for Success.
What is a 1031 Exchange?
A 1031 Exchange refers to the Federal Tax Code under Title 26, section 1031. This section allows for full deferment of income and capital gains taxes related to the sale of an income-producing or investment property and outlines the requirements to perform such an Exchange. It states that so long as the proceeds from the sale of a qualifying property are used to purchase a property or properties that are like-kind and that certain rules regarding the exchange are followed, then up to 100% of the taxes related to that sale of that property can be deferred. This section of the tax code also outlines the rules, timelines, and qualifiers for a tax deferred exchange. You are more than welcome to study this section of the tax code for yourself but allow me to break down the important points that cover most questions Exchangers regularly ask me.
Federal vs State on 1031 Exchanges
It is important to note that a 1031 Exchange falls under federal tax code and is not restricted by States. What this means for taxpayers and real estate investors is that not only does a 1031 Exchange defer Federal taxes, but it also defers State taxes. In addition to deferment of both sets of taxes, it also allows the Exchanger to sell in any state and exchange those proceeds into real property located in any other state in the United States. It is common practice for investors to perform a 1031 Exchange in high tax and high appreciation states, like California, and move all of those gains into higher cash flow or retirement friendly states, like Florida.
What taxes get deferred?
Federal Capital Gains Taxes which are typically 15% of the appreciated value on a property but can reach 20% based on income. State Capital Gains Taxes which vary from State to State and can range from 0% (Florida) to 13.3% (California) may also be included. Medicare Tax is 3.8% and Depreciation Recapture is 25% of the amount depreciated from the asset before sale. All of these taxes would be fully deferred by performing a successful 1031 exchange.
What does “like kind” mean?
Businesses and certain personal property formerly qualified for a 1031 exchange until the Tax Cuts and Jobs act removed these allowances from the Exchange Code at the beginning of 2018. Prior to this, “like-kind” referred to only allowing the exchanging business for business and real property for real property, with no crossover. Currently the only option available for exchange is real property for real property, and the IRS definition of “like-kind” real property is very broad. The only exact definition that does not fit “like-kind” according to the IRS is exchanging real property anywhere inside the United States for real property outside the United States. So long as you’re exchanging within the United States, ownership of real property can be shown through title, and the sale and purchase are related to income or investment purposes; it is considered “like-kind” and exchangeable through section 1031.
Who can exchange?
Individuals, C corporations, S corporations, general or limited partnerships, limited liability companies, trusts and any other taxpaying entities that hold real property for income or investment purposes qualify for Section 1031 deferrals. There are also ways that multiple taxpayers can own portions of the same property through a Tenants in Common title structure. This effectively allows multiple entities to exchange into and out of a single property and continue to defer taxes through the 1031 process.
What can’t I exchange?
Property held for a short period with the intent to sell it is excluded from a 1031 Exchange, such as residential fix & flips or vacant land that is developed and then sold shortly after development. The general rule of thumb here is that any investment real estate held for 2 years or more qualifies for a 1031 exchange. Anything held for less than 1 year does not. There are some rare exceptions of sales that are held for less than 2 years but more than 1 that qualify for a 1031 exchange. Primary residences do not qualify for a 1031 exchange, but they may qualify for other capital gains tax exemptions according to your state.
Businesses and inventory held for investment or income purposes no longer qualify for tax deferred exchanges, but if the business also owned the property included in the sale of a business and its inventory, the real estate would qualify for a tax deferred exchange. This same consideration may also be applied to real estate of which portions have been used for business or trade purposes but may otherwise be considered a personal residence; such as a spare bedroom used as an office, an accessory dwelling unit, or a pool house used for Airbnb. Determining whether your particular property qualifies for a 1031 exchange is in accordance with how taxes have been reported and your tax advisor should be able to accurately determine if all or a portion of your property qualifies for a tax deferred exchange.
Why perform a 1031 exchange?
There are many personal reasons to perform a 1031 exchange, such as consolidating many properties into fewer properties, diversifying fewer properties into more, trading appreciated low cash flow property for high cash flow property, maximizing purchase power through exchange equity and leverage, trading for higher basis property to take advantage of depreciation deduction, and even just acquiring property closer to the owner in the event of relocation.
Aside from personal reasons a real estate investor might want to perform a 1031 exchange, the ability to grow wealth through equity accumulation and cash flow increases is second to none. When 100% of all sales proceeds, both equity and appreciation, are allowed to be moved into the next investment property, true exponential growth can occur. A regular doubling of net worth is a common occurrence for investors that take regular advantage of the 1031 exchange.
A very important, and often overlooked, reason to consider a tax-deferred exchange is to take advantage of a step-up in basis for the heirs of the property owner. Since taxes are only deferred and not completely forgiven, all taxes come due upon sale of a property that is not exchanged, UNLESS that property is given as an inheritance through a living trust. In other words, the heirs receive a new basis in the property based upon its market value at the time of death and the built-in gain attributable to the taxpayer essentially disappears. Done correctly, using 1031 exchanges is not only one of the single best ways to grow wealth through real estate, but also to preserve it and pass it along to one’s children.
Now that I’ve explained the basics for what a 1031 Exchange is and the advantages of doing one, let’s head over to the next article and talk about the details of performing a 1031 Exchange.