REtipster provides real estate guidance — not tax or investment advice.
This article should not be interpreted as financial advice. Always seek the help of a licensed financial professional before taking action.
One of my biggest takeaways from this book was something called the “1031 Exchange“.
Like most of the wildly confusing tax codes and terminology the IRS has written, this strange-sounding term may not mean much to the average person – but if you're a real estate investor, and you're looking for ways to grow your real estate portfolio WITHOUT losing a huge portion of your wealth to taxes on the capital gains from the sale of your properties, this is a very important tax loophole to know about.
In short, “1031 exchange” is a nickname for Section 1031 of the U.S. Internal Revenue Service’s tax code.
This section states that if an individual exchanges one investment property for another (i.e. – sells one and uses the proceeds to buy another), they may be able to defer the taxable event of capital gains (or losses) they would normally have to pay at time of sale.
Think about it this way…
Let's say you buy a piece of real estate for $100,000 and then sell it for $500,000.
Since you're making a profit (i.e. – capital gains) of $400,000 on this sale, you would normally be required to pay taxes on this amount.
This kind of taxable event would cost the average tax payer a BIG pile of cash (like, somewhere in the neighborhood of $100,000 to $150,000… yeah, ouch), depending on which tax bracket they fall into.
However, if you utilize a 1031 exchange, instead of losing this massive portion of your $500,000 sale price, the IRS will allow you to defer your taxes.
In other words, you can use ALL of your $500,000 sale proceeds to purchase one (or more) new properties, and as long as you roll the full $500,000 amount into one or more new properties, you can potentially pay no capital gains tax at the time of sale.
This is a MAJOR tax benefit – because you'll have much more buying power for your new investment property (or properties), which in turn, should generate more cash flow and appreciate even further in the future.
Of course, whenever you eventually cash out and sell off these new properties, you'll have to pay taxes at that point – but in the meantime, you can make your money go further and work harder using a 1031 exchange.
Why is a 1031 Exchange Important?
Knowing when and how to use a 1031 exchange matters a great deal, because it will help you create more wealth WITHOUT taking a substantial tax hit along the way.
Investors can use 1031 exchanges throughout their careers to reap the rewards that come with buying bigger and better properties.
While a 1031 exchange is an incredibly powerful tax loophole to know about, there are several opportunities you'll have to mess up the process… and if you don't follow the proper procedures and time constraints that come with a 1031 exchange, you'll have to pay unanticipated taxes on the sale of your property.
What Types of Properties Quality for a 1031 Exchange?
Like many of the rules and regulations written by the IRS, the language in the tax code is rather vague.
When you're selling off one property and using the proceeds to buy another, both properties must be, “like-kind.”
“Both properties must be similar enough to qualify as “like-kind.” Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”
If you're confused about how to determine what like-kind means, you're not alone. This is why it is essential to secure professional help if you’re considering a 1031 exchange—there are pitfalls aplenty even for seasoned investors.
Robert Wood explains it well in this article from Forbes:
“Most exchanges must merely be of ‘like-kind’–an enigmatic phrase that doesn’t mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But again, there are traps for the unwary.”
Restrictions on 1031 Exchanges
Investors must consider additional restrictions, beyond the definition of “like-kind.” Again, a licensed tax professional will be able to illustrate each one, but a few major considerations include:
- You must own the real estate. Owning a share in a REIT, a fund or an LLC that owns a share in another LLC does not qualify.
- You can only perform a 1031 exchange between investment properties, but you can’t do this with personal property.
- If you exchange for a cheaper property, you’ll have to consider the taxes on the price difference.
- If you receive cash, relief from debt, or property that is not like-kind (e.g. – exchanging a piece of real estate for an airplane), you may trigger some taxable gains in the year of the exchange. It is possible to have both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.
- You can “delay” your exchange (which most people do), where a third party acts as an intermediary between you and a prospective future buyer.
There are some very important timing deadlines to consider with a 1031 exchange.
“The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.”
And that's not all, there's another deadline at the six month mark. The property,
“must be received and the exchange completed no later than 180 days after the sale of the exchanged property.”
While 1031 exchanges offer some major tax benefits, their execution is not for the faint of heart. If you miss one of these deadlines or fail to keep property documentation as required, you could end up paying taxes on the entire sale.
In a perfect world, a 1031 exchange would occur immediately, meaning the sale of the old property and the purchase of the new one occurs simultaneously.
That is difficult to enact, though – because real estate transactions have many moving pieces, and they generally aren't known for their speed. This kind of coordination would require an investor to find the perfect property at exactly the same time they wish to sell. This is why “deferred” exchanges are allowed.
Using a Qualified Intermediary
This means you can “sell” your property to a qualified intermediary, who then “buys” the property on the other end of the exchange. This ensures that the entire series of actions remains one transaction, rather than you receiving taxable cash for the sale.
When you complete a 1031 exchange, it's a good idea to use a qualified intermediary (aka – 1031 Accommodator). It's easiest to think of this like a special escrow account that holds your money, so you don’t have to touch it.
They will effectively take the sales proceeds from the first property, hold onto it and make sure it gets invested into the new property. They also fill out the documentation for the IRS. When you use a qualified intermediary, there’s not much documentation YOU have to do, because the intermediary handles it for you.
For the most part, any large title company can play the part of a qualified intermediary (small local offices usually aren’t equipped to do it). Likewise, a real estate attorney or CPA may be qualified to do this too.
The cost of the intermediary can vary, depending on the complexity of the situation. For simpler deals, it’s usually just a couple hundred dollars (like a separate closing cost in the deal), but the expense can get much higher when more complications are added to the overall transaction.
Is There An Easier Way?
As you read all of these mind-numbing rules and caveats, you might be temped to simply say “No thanks” out of sheer confusion. I know there can be a bit of fear about messing up the process.
But don't throw in the towel just yet.
RealtyMogul is a real estate crowdfunding website that allows investors to passively invest in fractional ownership of larger, commercial properties.
With RealtyMogul, you can essentially take the sales proceeds from your property, and rather than taking on the stress of finding another investment property within 45 days, you can simply invest your funds into a property through their platform.
Want to help support the REtipster Blog? Here's our affiliate link to RealtyMogul!
There are a few different scenarios where it might make sense to invest your cash into a crowdfunded project, rather than going it alone and relying on hopes and prayers for everything to come to fruition.
Scenario 1: When the Deal Falls Apart
It's not uncommon for investor has start the 180 timeframe to do a 1031 exchange, but then their deal falls apart. For one reason or another, they're unable to find a good alternative to invest their money into, and they simply need to put their cash somewhere before they run out of time.
In these situations, RealtyMogul provides a great “back door” that will allow the investor to place their money where they can still defer the taxes on their capital gains.
Scenario 2: When There's Excess Cash Leftover
In some cases, an investor may have found a new property, but the new deals only requires a portion of the total sale proceeds they received from their previous property. As such, they need somewhere else to put the remainder of their cash, in order to avoid paying taxes on the capital gains from this excess cash.
Again, RealtyMogul provides a great alternative solution, by allowing investors to inject this excess cash in increments as little as $5,000.
Scenario 3: The Reluctant Landlord
Sometimes an investor wants to keep their investment dollars in real estate, but they don't necessarily want to be a landlord or property manager (and all the headaches that can entail). For instance, if someone inherits an rental property, but doesn't want to get into the rental property business. Alternatively, if someone wants to “cash out” on the appreciation their property has earned, but they don't want to upsize to a larger property with bigger problems to manage.
With RealtyMogul, you can still be a passive real estate investor by contributing a portion of the overall proceeds and letting the professionals deal with the hands-on work. When your full-time job is NOT as a real estate investor and you're busy with other things, you may want to do less work and put the day-to-day tasks on someone else who is geared up to handle them (so you don't have to deal with tenants, leases, repairs, trash, etc.).
Surety of Closing
One of the biggest benefits of working with RealtyMogul is the surety of closing.
When an investor commits their funds to one of these projects, they don’t have to worry about the deal falling apart between the 45 and 180 day timeline, because the properties have already been acquired and the financing is in place. RealtyMogul doesn't even bring in the investors until after these milestones have been reached.
It's also a much faster process. When you commit to a project with RealtyMogul, you don't have to wait weeks for a closing, the funds typically take 3 – 5 business days to go through.
From what I know of this outfit, RealtyMogul is one of the more conservative companies in the real estate crowdfunding space, and they do a great deal of vetting on each property they get involved with. Of course, there's never any guarantee as to how your investment dollars will perform with a company like this, but if you want to work with a company that does regular site visits on every property and is intimately familiar with the numbers on every deal (and can offer a much easier path to completing a 1031 exchange), this could be a company worth your consideration.