What is a 1031 Exchange, and when should you be using it?
Like most people, I know I have to pay taxes to be a good citizen and, you know, not go to jail. That being said, I also don't want to pay a penny more than I'm required. Luckily, real estate investors have a trick up their sleeve. Like a magician, we can make capital gains from the sale of property disappear! Ok, ok. Like any magic trick, the taxes aren't actually gone, but they are differed until later.
Simply put, a Section 1031 Tax-Deferred Exchange allows you to defer the capital gains you would normally incur on the sale of a property or business. You might be asking yourself, "Tim, aren't you just putting off the inevitable? What is the advantage of deferring those capital gains taxes?" Very astute observation and poignant question dear reader! Well, in this instance, procrastination works in your economic favor.
Conventional wisdom tells us that cash in hand is always worth more now than later. The reason is, if it is not invested or in a high interest-earning account, it just sits around withering away thanks to depreciation. That being the case, if we keep that money that would otherwise be paid in taxes, we have the opportunity to invest it and make it work for us.
What it looks like in practice
Let me illustrate my last point with two different scenarios, one where we sell the property and take the proceeds and pay the long-term capital gains tax and another where we do a 1031 exchange.
Scenario 1 (traditional property sale)
Let's say you bought an investment property in your town for $100k five years ago. It has been bringing in a few hundred dollars in profit every month, so you've been pretty happy with it, but more and more repairs keep coming up, and you're ready to get rid of it. Lucky for you, the property has appreciated and is now worth $150k. You have a mortgage balance of about $67k, so after the agent's cut, you will still see a nice profit of about $74k.
Not bad at all, but now the taxman steps in and politely asks for his share, which for most of us will be 15%. That comes out to more than $11k, leaving you with about $63k. Still not bad, but assuming you don't NEED that money right now and can afford to invest it, let's see how scenario 2 plays out a little differently.
Scenario 2 (using a 1031 exchange)
Now let's assume that you've read this super informative blog post and are keenly aware of the potential advantages offered by a 1031 exchange. All the numbers for the sale of your property are the same, but instead of keeping the sale profits, you 1031 exchange them into another, larger property.
With your $74k, you can put a 25% down payment (standard for multifamily investment properties) into a triplex selling for $295k. Not only did the 1031 exchange allow you to defer taxes, but it also increased your purchasing power toward a larger investment property. If done right, properties with more units have the potential to bring in greater cashflow and reduce risk from vacancy.
What's the catch?
As with all things, there is a bit of a catch. You must adhere to the IRS's guidance when it comes to completing a 1031 exchange. These rules are relatively straightforward but do take some planning.
Find a qualified intermediary (QI). When you complete the sale of the first property, the sale proceeds will need to go to this third-party QI. In other words, your hands can never touch the money
Identify a replacement property within 45 days. It is important to note that you must use the full proceeds from the sold property into the replacement property to defer all taxes
Close on a previously identified replacement property within 180 days of the sale of your original property
I will caveat everything here by saying that this was a broad overview and besides not being a lawyer or CPA, I couldn't possibly touch on the legal nuances or individual circumstances you might have.
My recommendation is that if this strategy sounds like it might make sense for you, you should speak with a QI. I have personally used ERG in my transactions, so I recommend them, but do your research as there are some shady firms out there, and you don't want to find yourself on the next episode of American Greed.
My favorite part of the 1031 exchange is that in the worst-case scenario that you cannot find a replacement property in the allotted time, you wind up paying the taxes on profits that you would have paid anyway. But the idea of repeatedly deferring taxes and trading up for larger, more valuable investment properties is certainly worth the risk.
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