Summary: Real estate investors take advantage of tax-free appreciation by using 1031 exchanges to move up from one property to another. Since 1031 exchanges serve such an important role in building generational wealth, this post covers the basic rules and the steps you need to successfully pull off your next 1031 exchange. By the time you’re done reading it, you should be ready to do your very own 1031 exchange.
If you’ve been investing in real estate very long, odds are you’ve heard of a 1031 exchange. Maybe you’ve even thought of doing one or know someone who has.
Since we just finished another 1031, we thought it was about time to write a comprehensive guide of how you too can use this tax loophole to buy and sell investment properties tax-deferred (or even tax-free).
In this post, we explore why people do 1031 exchanges, and when you should consider doing one. We also walk you through the limitations. By the end of this post, you should know how to do your very own exchange and be well on your way to scaling up your real estate portfolio (and your wealth)!
What is a 1031 exchange?
A 1031 exchange essentially trading up one investment property for another tax-free.
Because it allows you to move from investment property to property, leveraging your appreciation tax-free with each move, the 1031 exchange forms the backbone of many peoples’ real estate portfolio growth. This is all to say it is a powerful way to build wealth, and is something you must understand and become facile with if you want to achieve financial freedom quickly (what we call Fast FIRE).
Note in this post, I am referencing delayed-type 1031 exchanges, not reverse, simultaneous or construction/improvement exchanges. This is because delayed 1031 exchanges are the most frequently-used version of the 1031.
What is the alternative to doing a 1031 exchange?
The alternative to doing a 1031 exchange is to just sell your investment property. When this happens, gains are taxed as ordinary income if you’ve owned the property for less than a year or as capital gains if you’ve owned the property for over a year. Keep in mind the taxes can really add up since you’re paying on the basis.
What does that mean?
I think this is best explained in an example.
Let’s say you buy an investment SFH for $100,000. You rent it out for 10 years and then just sell it for $150,000. Ignoring the costs of sale for simplicity, you’ve made $50,000 in appreciation on the property.
Here’s the catch.
You don’t pay long term capital gains on just that $50,000. That’s because over those 10 years, you’ve been diligently writing off your depreciation (let’s say depreciation has been $3,000 per year – for a total of $30,000). Plus you’ve been writing off expenses for repairs and services (let’s say that’s another $30,000 worth). Find out more about bonus depreciation HERE.
So now you’re looking at paying a capital gains rate tax on $50,000 in appreciation + $30,ooo worth of depreciation recapture + $30,000 worth of expenses. So you’re going to pay approximately 23% tax on $110,ooo = $25,000. That’s a huge chunk of cash to cough up! Now you’re only walking away from the sale with half your profit.
But what if you did a 1031 exchange here and paid no taxes?
When should I do a 1031 exchange?
You should do a 1031 exchange whenever you are selling an investment property and you can meet the tax code requirements. I know that’s broad, so lets cover some of the limitations on the tax code.
First, to do a 1031 exchange, you must be selling and buying like-kind properties. This means that you are trading an investment property for an investment property. For example, you could take a duplex and buy a four-plex. You could take a single family home that you rent out and buy an apartment building. You can even take something like a four-plex and buy raw land (though you better make sure it meets some of the other criteria below). What you can’t do is take your vacation house and buy a rental property. Or take your investment property and buy a primary residence. Make sense?
You must use an intermediary to do a delayed-type exchange. This means that once you sell your investment property, the funds are transferred directly to a 1031 exchange company that holds the funds until they are transferred to the bank for your next property. You CANNOT touch the funds yourself or the whole thing is voided. There a numerous 1031 companies who can serve as an intermediary. If you want our recommendations, check here.
Numbers to know on 1031 exchanges
You must pick a new property to buy with the funds within 45 days. This one is the killer. Basically, within 45 days of selling your property, you have to submit a list of three or less properties that you intend to buy to your 1031 exchange company. Then, within 180 days, you must close on at least one of those properties.
This timeline is tough – so what we’ve done to mitigate it, is to get our property under contract with a super long close date (60+ days if possible). Then we have the 60 days +45 more to find another property. It’s still stressful, but at least it takes some of the pressure off.
You need to at least buy a property of the same cost or scale up (and scale up your debt too). This is all to say, that you’re new property (or properties) must be at least the same cost or more as the property you are selling and your loan amount must also be at least the same or higher.
For example, some of you may remember that Kenji and I sold a duplex in the Seattle area last year for $870,000. We then used a 1031 exchange to buy a six-plex in OKC ($301,000) and a mixed-use property ($600,000) in Spokane. It was complicated, but it ended up working.
How do I do a 1031 exchange?
Let’s tackle what happens when the rubber meets the road. Here’s are the steps to a delayed-type 1031 exchange.
First, either identify a property you want to sell and put it up for sale OR find a property you want to buy.
Why are there two choices here? That’s because you have the choice to get a property you want to sell under contract (with a delayed close) OR you have the choice to get a property you want to buy under contract (with a contingency that you have to sell your other property using a 1031 exchange to buy that one).
At the same time, you should identify a 1031 intermediary so you’re all set up when the money starts to exchange hands.
Once you have your property sold, send your list of identified exchange properties (up to 3) to your intermediary within 45 days of closing.
Then make sure you buy one of those properties. Your intermediary will hold the money in between the sold date and buy date.
Finally, make sure you’re tax person is kept well-abreast of the fact you’re doing a 1031 exchange. Ultimately, you can rely on your tax accountant for questions as well, since he/she is ultimately going to need to make sure that everything in the exchange was kosher enough to avoid any tax payments.
What happens if I sell the property down the road and don’t do another 1031 exchange?
If you do several 1031 exchanges and then decide to sell a property, keep in mind that all the write-offs and depreciation you’ve taken over the years will add up to increase your tax basis. Ultimately you’ll be paying a ton of deferred taxes when you do sell.
The way to avoid this is to NOT sell your property and just pass it off to your heirs. At the time of your death, a new basis is set based on the value of the property at the time of your death. So your heirs don’t need to pay for those years of tax-free 1031 exchanges.
Now that is passing down wealth.
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