If you’re interested in real estate investing, you need to know about 1031 exchanges. Why? This type of transaction can help scale and optimize your portfolio when executed strategically and under the right circumstances.
When you sell an investment property, you’ll pay some hefty capital gains taxes at the time of the sale if you have gains. These taxes will surface at the federal level. The amount will vary based on your income, but in most cases you’re looking at around 15%-20% for federal taxes on capital gains.
Depending on where you live, gain could also be taxed as income or gain at the state level. Further, accumulated depreciation recapture hangs around till the last mile and is taxed at a federal rate of 25%, with varying results at the state level. It would be advisable to get in touch with your CPA for a translation. (In some cases, capital gains taxes can go up to 28 percent).
However, you won’t owe any taxes at the time of sale if you execute your 1031 deferred exchange properly.
Also known as a “like-kind” exchange, a 1031 deferred exchange allows you to defer all capital gains taxes if you reinvest the proceeds in a new property or portfolio of properties of equal or higher value and maintain similar or higher loan amounts. There are other things that need to be considered, but these are the two big ones.
Did you know? You have to hire a Qualified Intermediary (QI) to facilitate 1031 tax-deferred exchanges. Nationwide, the average cost of a QI is around $1,250.
Pros of a 1031 exchange
Beyond the obvious plus of deferring capital gains taxes, there are a number of other reasons why 1031 exchanges are an attractive option for property investors. Here are a six key benefits:
#1: Opportunity to invest in a portfolio
“Like-kind” doesn’t necessarily mean a house for a house. It just means the new investment has to be investment real estate. The recent changes in tax law eliminated all exchange types except for real estate.
This means real estate investors win. Some of the most astute real estate investors have 1031 exchanged a single-family home in a highly appreciated market such as California in order to purchase a portfolio of rental properties in a lower volatility/more affordable state with better cash flow, which can generate greater returns over time.
#2: Ability to elect to reset your depreciation
As a property owner, you can write off “depreciation” of your asset to compensate for deterioration related to the wear and tear, aging or other structural obsolescence of the home. For example, the IRS recognizes 27.5 years as the depreciable time period for an investment property (your CPA can describe other acceptable methods). This means that every year, the amount of the value of your “improvements” (the value of the building) divided by 27.5 can be deducted from ordinary taxable income for 27.5 years. Translation: You have the potential to reduce the amount of income taxes you pay because of depreciation.
However, overall appreciation is typically realized in the value of the land and not the property. This is because assessors typically don’t have information on improvements made to the property unless there is a sale. So while your property may have increased in value based on structural improvements, you may only be able to achieve a similar benefit of depreciation as when you initially bought the property.
In a 1031 deferred exchange, your CPA may elect to reset the depreciable amount of your investment property to a higher value that would give you a bigger tax benefit. Again, see your CPA for a translation.
#3: Exposure to new markets
Want to invest in a market with growing potential? Like-kind exchanges aren’t constrained within state lines. This means you can capitalize on one of real estate’s best advantages, which is the diversification of risk. Getting your foot in the door of an up-and-coming market early could lead to bigger returns down the road.
#4: Trade up for higher-value properties
A 1031 deferred exchange lets you trade up to a property or portfolio of properties with higher returns or qualities that better match your investing goals — and you won’t have to pay tax on the new investment until you sell (unless you choose to do another 1031 exchange).
#5: Greater exit flexibility
Single-family homes can be traded in smaller amounts, which provides flexibility and freedom.
Purchasing a portfolio of single family rental properties gives you the flexibility to sell portions of your assets over time, on your time. One of the great things about single-family rental properties is the ability to accessorize. Commercial real estate typically trades in one big lump, which can create liquidity constraints. Single-family homes can be traded in smaller amounts, which provides flexibility and freedom.
#6: Build equity over time
There’s no cap on how many times you can do a 1031 exchange. That means you could turn a duplex into a fourplex into a single-family rental portfolio into a real estate empire.
Cons of a 1031 exchange
While 1031 exchanges can be a fruitful strategy, there are a couple of challenges to be aware of before you start the process.
#1 There’s a tight timeline
There are very strict timeline requirements when it comes to 1031 exchanges. You have 45 days to identify which property(s) you plan to buy, and you must close on that property(s) within 180 days. So if you’re not prepared to make things happen quickly, a 1031 exchange may not be the best option.
#2 Finding “like-kind” properties can be difficult
In order to do a 1031 exchange, you must first identify which property(s) you’d like to invest the money in. However, it can be very challenging to find “like-kind” replacement properties that fit the bill, especially within the time constraints of 1031 exchanges. Keep in mind, gains deferred in a 1031 exchange are tax-deferred, but not tax-free. Have the right plan and resources in place. You don’t want to scramble and end up with a subpar property that doesn’t fit your long-term investment goals just to avoid taxes. Or worse yet, you could have to pay taxes on the entire gain.
#3 You’re taxed on “boot”
If you have any cash left from the sale after you close, the Qualified Intermediary will pay it back to you. However, that money (referred to as “boot”) is taxed as capital gains. Additionally, as we mentioned earlier in this article, accumulated depreciation recapture hangs around till the last mile and is taxed at a federal rate of 25%, with varying results at the state level.
If you used leverage, you also need take your loans into account, both on the property you’re selling and the new one(s) you’re purchasing. If your liability is going down, it will be treated and taxed just like cash boot.
Say, for example, you had a mortgage of $1M on the old property, but a mortgage of just $800K on the exchange property. You’d be taxed on that $200K gain.
