A 1031 Exchange allows real estate investors to defer the capital gains tax and use the full proceeds from a sale towards the purchase of another property.
What is a 1031 Exchange?
A 1031 Exchange is derived from IRC Section 1031, which states states:
No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
This allows investors to defer the capital gains tax from a sale of a property and invest the proceeds into another property, often called “trading up”.
For example, an investor purchases a property in 2015 for $1,000,000, by 2020 the property appreciates to $1,750,000 and the investor decides to sell. The capital gain from that sale is $750,000, and tax will have to be paid on that gain.
If the investor decides to utilize a 1031 exchange, they can invest the entire sale proceeds of $1,750,000 into another property and defer paying taxes on the gain.
Benefits of a 1031 Exchange
1031 exchanges can help investors grow their wealth faster because by deferring the capital gains tax, the entire sales proceeds can go to purchasing a larger property.
In the example above, the investor would normally have to pay a tax of $178,500 (23.8%) on the $750,000 gain. A tax bill that large obviously negatively affects your ability to continue growing your capital. At a 75% loan-to-value ratio (LTV), the tax bill of $178,500 reduces your purchasing power by $714,000 ($178,500 / 25%).
That’s a huge loss of purchasing power! But by utilizing a 1031, you can retain that purchasing power and roll it into the next property. This is again due to the fact that you will not owe capital gain tax on your 1031 funds.
Another benefit of 1031 exchanges is the deferred taxes owed to the IRS are erased upon death. Utilizing this strategy can be powerful as investors can use multiple 1031 exchanges to purchase larger and larger properties throughout their lifetime, thus growing their wealth tax free. When the investor passes away, their heirs will receive the property at whats called a stepped up basis equal to the fair market value of the property at the time of death, thus eliminating any tax liability.
Drawbacks of a 1031 Exchange
There are a strict set rules that must be followed in order to complete a successful 1031 exchange. So while 1031 exchanges can be a powerful tool for building wealth, there are some drawbacks if not used properly.
For starters, a qualified intermediary must be used to handle all the paperwork and hold the sale proceeds during the exchange period.
The investor will have a 45-Day Identification Period, starting at the closing of the disposed property, to identify up to 3 properties to purchase. If the properties are not identified within the 45 day period then the 1031 exchange is a failure, the proceeds from the sale will be returned to the investor and he/she will be unable to defer the capital gains tax.
Additionally, there is a 180-Day Exchange period in which the acquisition of the identified properties must be completed. Failure to take ownership on or before the 180 period will result in a failed exchange.
There are other rules while attempting a 1031 exchange that allow you to “identify” more than three properties. These rules are known as the 200% rule, the 95% rule, and the Incidental Property rule. Though these rules are beyond the scope of this article, it is best to work with professionals throughout the process and start preparing for the exchange (i.e. looking for potential properties) prior to the sale of the property you would like to exchange.
Also, if the investor utilizes multiple 1031 exchanges and eventually fails to complete one, the sales proceeds will be returned, and part or all the deferred taxes from prior exchanges must be paid. This can be a pretty hefty tax bill depending on amount and size of the previous exchanges.
Lastly, a major con that we see in dealing with our clients is the fact that your basis in your replacement property does not increase proportionately to the increase in market value. This means that over time, your depreciation expense will not shelter your rental income nearly as well as it did in the past.
For example, you purchase a $100,000 property. A few years later, it’s worth $200,000 and you decide to sell via a 1031 exchange. You acquire a $200,000 property as a result of the exchange. Your basis in the new $200,000 is the same as the original relinquished property, or $100,000. A decade and several exchanges go by. You now own a $1,000,000 property with the same $100,000 basis of the original property. This means you have high cash flow and net income generated by a $1,000,000 property with a depreciation shelter of a $100,000 property. Basically, you are going to pay hefty taxes.
The above was a simplistic example meant to illustrate a point. Generally speaking, your basis will not remain that static $100,000 in the example above. Instead, it will scale as you buy larger property because you are bringing outside cash to the table or increasing/decreasing your leverage.
But the point is that if you’re not careful, you can end up with a financially strong asset with nothing to shelter the income.
The Bottom Line
If used properly, the ability to defer the capital gains tax and use the entire proceeds from a sale to buy larger properties through 1031 exchanges can be a powerful tool for building wealth over a lifetime. 1031 exchanges can also be used to completely avoid paying the deferred capital gains taxes by passing the property down to your heirs when you pass away.
If you are planning to sell an investment property you own or plan to accumulate properties throughout your lifetime then benefits of utilizing a 1031 exchange make it worth considering. If you do determine that a 1031 exchange is right for you then it is important that you work with qualified professionals to ensure all the rules are being followed.