two real estate investors prepping to paint the interior of their renovation
BRRRR: The Ultimate Tax Smart Real Estate Investing Strategy
July 9, 2024

July 11, 2024
Last Updated : July 12, 2024

The 1031 Exchange: The Wealth Building Strategy for Real Estate Investors

In the previous article, we explored the Buy, Rehab, Rent, Refinance, Repeat (BRRRR) strategy—a powerful method for growing your real estate portfolio without incurring capital gains tax.

Today, we’re exploring another strategy that’s perfect for those times when selling a property becomes necessary.

Whether you’re reacting to changing market conditions or dealing with property-specific issues, there’s a way to exit your investment without a hefty tax bill.

Enter the 1031 Exchange.

What is a 1031 “Like-Kind” Exchange?

A 1031 Exchange, named after Section 1031 of the Internal Revenue Code, allows you to “swap” one investment property for another “like-kind” property, deferring the capital gains taxes that would typically be due on a sale.

This “like-kind” exchange generally applies to real estate used for business or investment purposes, such as trading an apartment complex for a medical building or a rental home for raw land. However, it doesn’t cover personal residences or properties held for resale (i.e., flips).

The Tax Benefits of a 1031 Exchange

The primary advantage of a 1031 Exchange is the deferral of capital gains and depreciation recapture taxes. This tax deferral lets you reinvest the entire proceeds from your property sale into a new property, maximizing your investment capital.

Scenario Comparison: Outright Sale vs. 1031 Exchange

Scenario 1:

Outright Sale: Imagine you own a property purchased for $300,000, now worth $600,000.

Selling it outright means:

  • Capital gain: $300,000
  • Federal long-term capital gains tax (20%): $60,000
  • Net investment income tax (3.8%): $11,400
  • State tax (5%): $15,000

You’d owe $86,400 in taxes, leaving you with $513,600 to reinvest.

Scenario 2: 1031 Exchange

Using a 1031 Exchange, you defer the $86,400 in taxes, allowing you to reinvest the full $600,000.

This additional $86,400 can significantly enhance your purchasing power, especially when leveraging a loan-to-value (LTV) ratio. With a 75% LTV, that $86,400 could equate to $345,600 in additional purchasing power.

Understanding the 1031 Exchange Rules and Timelines

A successful 1031 Exchange requires precision and adherence to specific timelines:

  • 45 Days: Identify potential replacement properties.
  • 180 Days: Complete the purchase of the new property.

The replacement property must be of equal or greater value than the original, and all sale proceeds must be reinvested. Failure to meet these criteria may result in capital gains taxes.

The Downside: Basis Erosion

While 1031 Exchanges offer substantial tax benefits, they come with a caveat known as “basis erosion.” Over time, as you depreciate your properties and defer capital gains through multiple exchanges, your tax basis decreases, leading to higher potential capital gains when you finally sell without reinvesting in another exchange.

For instance, if you bought a property for $400,000 and depreciated it by $100,000, your adjusted basis would be $300,000. If you then perform a 1031 Exchange for a new property worth $500,000, your new tax basis is $400,000 (adjusted basis plus the difference in value).

The Ultimate Strategy: Swap Till You Drop

“Swap Till You Drop” leverages continuous 1031 Exchanges to defer taxes indefinitely.

The strategy hinges on the step-up in basis at death. When you pass, your heirs inherit the property at its current market value, effectively erasing the deferred capital gains.

Practical Steps for Real Estate Investors

  • Identify Opportunities: Look for properties that align with your investment goals and qualify for like-kind exchange.
  • Consult Professionals: Work with a qualified intermediary (QI) and a tax advisor to navigate the complexities of 1031 Exchanges.
  • Plan Your Timeline: Be diligent about the 45-day identification and 180-day closing windows.
  • Maximize Leverage: Use the tax deferral to enhance your purchasing power and expand your portfolio.

The Last Word

The Swap Till You Drop strategy is a powerful tool for real estate investors looking to defer taxes and build long-term wealth. Combined with the BRRRR method, it offers a dynamic approach to real estate investing that can significantly enhance your financial outcomes.

Whether dealing with single-family rentals, office buildings, or short-term rentals, this strategy can be adapted to fit various investment types. As always, consult with experts to ensure compliance and optimize your tax benefits.

Partner with our team to explore the potential of 1031 Exchanges & “Swap Till You Drop” in your wealth-building strategy.