In this article I am going to discuss one of the best kept secrets in the US tax code. This is known as the “1031 Exchange”. The name comes from the law being in section 1031 of the Internal Revenue Code. As most people know, whenever you sell something for more than you paid for it, you have to pay taxes on that gain. However, with a 1031 exchange you have the ability to delay or completely eliminate paying these taxes. This is basically the IRS’ gift to real estate investors.
The basic rule behind using a 1031 exchange is that the proceeds have to be used on a “like-kind” asset of equal or greater value. This would mean that you sell a piece of real estate and have to purchase another piece of real estate with those proceeds. There is no restriction as to what type of real estate, for example you could sell a single family house and trade up to something larger like a multi family or commercial building. This is probably the most common use and where the 1031 exchange really shines.
Normally, when you sell something outright you are forced to pay a decent chunk of capital gains taxes if it went up in value from what you paid for it. With the 1031 exchange, you can keep all of this money and put it into another property or properties of equal or greater value. This gives you way more purchasing power than if you would have had to pay taxes and lets you greatly speed up the wealth building process. Think of it like the game of Monopoly. You are trading in your houses to get a hotel. It is the same concept as that. You can keep repeating this over and over until you eventually work up to a large apartment or commercial building.
Now you might be wondering when these taxes are going to be due since I said the 1031 exchange just defers them. Under normal circumstances, if you decide to sell your portfolio when you are older and tired of managing them, you will be required to pay the taxes at that point in time. However, you can still get around this. If you just hold onto your properties until you pass away your heirs can inherit them under what is called a “step-up basis”. This basically means that they get the properties at today’s market value and everything before that is wiped away. They are responsible for paying basically no taxes!! This is probably the best way to go since you can give your heirs a large asset and they won’t have any taxes to pay on it.
I will detail an example of a 1031 exchange so everyone is sure to understand it. Lets say Joe went out and bought a single family home for $50,000 and put about $25,000 of work into it to fix it up. 3 years later, he goes and sells this property for $110,000 and decides to execute a 1031 exchange with the proceeds. Normally, Joe would be responsible for paying capital gains tax on the $35,000 gain from what he put into the property. Instead, he can go and spend that $110,000 he got from the sale and buy something bigger like a 4 unit apartment building. Without executing this 1031 exchange he wouldn’t have had enough money to do this. Done over and over, you can see how powerful this can end up being!
There are a few caveats of the 1031 exchange that you need to be aware of when executing it. I won’t go into great detail in this article but I will give a quick run down of them. First, the money from the sale of the first property must be held by a “qualified intermediary”. Essentially this means you can’t touch the money in between the sale of the first and the purchase of the new property. Also, There are time limits as to how long you have to identify and buy the new property after the first one is sold. You must identify a new property within 45 days of the first property being sold. You must also close on this new property within 180 days of the first one being sold. These rules must be met or the 1031 exchange will not work. My best advice would be to start looking for the new property whenever you list the original property for sale.
If you keep these guidelines in mind a 1031 exchange can be a great way to really accelerate the building of your portfolio. Going this route will help you acquire properties much faster than if you were to pay the taxes every time you sell a property. I would definitely recommend utilizing it if you are a buy and hold investor. Just make sure you keep the rules in mind so that everything goes smoothly!