Summary: Investing in cashflowing rentals isn’t just about the cashflow. Savvy investors also use appreciation to make large leaps in net worth when they exchange them for bigger properties in a tax deferred way using a 1031 exchange. This is one of the keys to achieving Fast FIRE. Since 1031 exchanges play 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.
If you’ve been reading or listening to podcasts about real estate, odds are you’ve heard of a 1031 exchange.
Since we just did our second 1031 in the last six months, we thought it was about time to write about it for our readers and more importantly, how you can use it to accelerate your path to Fast FIRE (i.e., financial freedom while you are still young enough to enjoy it).
But before diving into 1031 exchanges, let’s talk about where 1031 exchanges fit into the big picture of cashflowing rentals.
In a previous article, we shared how our portfolio grows at a rate of return of 25% plus. You get 25% when you factor in the cash-on-cash return, equity paydown, tax savings, and the compound interest from reinvesting the cashflow and tax savings. The “plus” comes from taking advantage of appreciation and trading up to bigger properties. When you do this, your return skyrockets.
For example, we bought a property that appreciated $250,000 in two years. Instead of having that equity sit in our property, we exchanged the property for a larger one. (Actually, we bought two properties with the proceeds of the sale).
The problem is the tax bill. A big one is on the way should you sell.
This is where 1031 exchanges come into the picture.
What is a 1031 Exchange?
A 1031 exchange is a government tax incentive. It comes from the section of the IRS that describes the rule in detail.
The ruling allows you to sell a property, take all the proceeds, and buy another property. The taxes on this transaction are deferred to a later date when you stop doing 1031 exchanges and eventually sell a future property.
Because it allows you to move from investment property to property, leveraging your appreciation tax-free with each move, the 1031 exchange enables you to grow your portfolio very quickly.
This is all to say it is a powerful way to build wealth, and it is something you must understand and become facile with if you want to achieve Fast FIRE.
Note: In this post, I refer to 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 long term capital gains if you’ve owned the property for over a year. Keep in mind the taxes can really add up.
So what exactly do you pay in taxes?
I think it’s best to give an example here.
Let’s say you buy a single family home to use as a rental for $100,000. You rent it out for 10 years and then sell it for $150,000. Ignoring the costs of sale for simplicity, you’ve made $50,000 in appreciation on the property. You pay approximately 23% long term capital gains tax on the $50,000 or $11,500.
A fairly hefty amount. But the taxes don’t end there. There’s something called depreciation recapture, which is when you have to pay for all of the depreciation you claimed over the years and pay taxes on that amount. But this time, you pay the ordinary income tax rate.
So using the example above, let’s assume that you’ve been diligently writing off your depreciation over the 10 years. So if your depreciation has been $3,000 per year, you have a total depreciation recapture of $30,000 taxed at ordinary income tax rates!
The 1031 exchange allows you to defer all of these taxes to a later date.
What are the Basic Rules for Doing a 1031 Exchange?
You can’t just do a 1031 exchange on any property. You must follow strict rules in order for your exchange to qualify. If you fail to follow any of the rules, your exchange could be invalidated. Let’s cover some of these basic rules.
[Author’s Note: this isn’t a comprehensive list of rules. Be sure to use a qualified 1031 exchange intermediary and consult with your tax consultant whenever you are contemplating doing a 1031 exchange.]
The exchange must involve like-kind properties. This means that you are trading an investment property for another 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 that you intend to use for investment purposes. It’s important to 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. 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 escrow company that is handling the purchase of your next property. You CANNOT touch the funds yourself or the whole thing is voided.
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 have documented and signed a list of up to three properties that you intend to buy. Then, within 180 days, you must close on at least one of those properties. This timeline is tough and is one of the main reasons people fail to complete a 1031 exchange.
Your 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.
When Do You Pay the Taxman?
Remember that 1031 exchanges aren’t tax-free. They are in fact tax-deferred, which means that you are just delaying the taxes until a later date. So if you get to a point where you want to just sell and NOT do a 1031 exchange, then this is when you pay taxes.
And remember that you not only pay taxes on the appreciation but also all of the depreciation you’ve taken over the years. Ultimately you’ll be paying a ton of deferred taxes when you do sell.
Now there is one trick to avoid paying taxes altogether. The way to do this is to pass your property off to your heirs. When you die, it sets a new basis 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 deferred taxes.
Now that is passing down wealth and one of the keys to creating generational wealth and a legacy for your family.
Are you planning to do a 1031 exchange? Have you already done one? Tell us about it!
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