A 1031 exchange allows you to expand your real estate portfolio with your own tax dollars. As with every other aspect of your real estate investing career, harnessing this powerful tax strategy will require your attention and effort. But if you’ve already purchased and managed an investment property, it’s beyond beneficial to learn how to execute 1031 exchanges.
To get started, you should first determine if a 1031 exchange is appropriate for your property and then calculate your reinvestment requirements.
What is a 1031 Exchange?
Section 1031 of the IRS tax code allows you to sell an investment property and use that money to buy more investment property, as opposed to paying taxes on capital gains. To be sure, the taxes will be due at some point in the future. But by deferring payment, your capital gains will continue to work to your benefit for the time being.
What’s even better, this tax-deferral strategy can work indefinitely—so long as you adhere to certain rules. Here’s how to forecast the gain and tax on your property sale, as well as the 1031 exchange reinvestment requirements to put off that tax hit.
Does Your Profit Justify a 1031 Exchange?
Before deciding to move forward, your first step should be to determine if there is sufficient gain and tax liability on your transaction to justify a 1031 exchange.
To calculate your gain, subtract closing costs and the adjusted basis from the sale price of your property:
Sale Price – Closing Costs/Commissions/Exchange Fee/Etc. – Adjusted Basis = Gain
Let’s assume a $225,000 selling price, $8,000 in allowable costs and fees, and a $75,000 basis in the property. The gain will amount to:
$225,000 – $8,000 – $75,000 = $142,000
If your tax rate is 15 percent, the federal tax on your gain will be:
$142,000 * .15 = $21,300
So, you’ll have two options: fork over $21,300 to Uncle Sam or complete a 1031 exchange and reinvest it all.
Obviously, your numbers will differ, and it’s up to you to decide which route is best for your specific situation. But many of the best investors are choosing to defer the tax and grow their own holdings with those tax dollars.
Note that, as of this writing, all states with income taxes—except for Pennsylvania—also allow you to defer state tax on gains. (Don’t stress, Pennsylvania investors! You can still defer federal tax and depreciation recapture.)
Sell Then Reinvest
Once you decide to move forward, the steps to defer all tax using a basic 1031 exchange are pretty straightforward.
- Sell your investment property using a qualified intermediary (QI) to document the process and ensure the transfer of proceeds.
- Then, following the time period and title requirements, reinvest the net sale price, including net cash received, into the purchase of another investment property held for productive use of equal or greater value.
1031 Exchange Reinvestment Requirements
Let’s dive deeper into the nitty-gritty of the two reinvestment requirements. In order to defer all tax, the following conditions must be met:
- The replacement property that you exchange into must be of equal or greater value than the net sale price of the property that you sold. This is called the “Equal or Up” rule.
- You must use all of the net cash received in the purchase of your replacement investment property.
How to Calculate Net Sale Price and Net Cash
When you execute a 1031 exchange, your tax deferral is dependent on the reinvestment of both the net sale price and the net cash received. You can forecast both using the formulas outlined below.
The resulting numbers can be used as an estimate of the amount that you’ll need to reinvest.
NET SALE PRICE
As the sales price of investment real estate does not represent what you actually receive, the IRS allows you to deduct certain associated costs from the sales price. This ends up being advantageous, but it involves some calculating. To determine the net sale price, which is your minimum reinvestment target, plug in the appropriate values in the following equation:
Sales Price – Closing Costs/Commissions/Exchange Fee/Etc. = Net Sale Price
For example, let’s say you’re selling your property for $225,000. Your realtor can provide you with an estimate of closing costs when you are listing the property or the title company will provide them on the final closing documents after the sale.
Let’s assume $8,000 in closing costs, commissions, and the exchange fee for our example:
$225,000 – $8,000 = $217,000 Net Sale Price
So, $217,000 will be your reinvestment target. In other words, in order to defer all tax using our example, you must purchase a replacement property for $217,000 or more.
You must also use all of the cash proceeds in the purchase of the replacement property. This amount is detailed on your settlement statement after closing. It can also be calculated by subtracting any mortgages and/or liabilities from the net sale price.
Net Sale Price – Mortgage/Liabilities = Net Cash (aka Net Proceeds)
Many investors argue that their original cash investment in a property should not be included in the net cash after the sale. It’s money that you put into the property. Why can’t you take it out at this point?
Unfortunately, the IRS doesn’t see it that way—and they create the rules. If you choose to take out even a single dollar of the net cash after your sale, you will pay taxes on any funds not reinvested. That’s even if the property you purchase is of equal or greater value.
In sum, to qualify for a full deferment, you must reinvest all of your net cash into a property that is of equal or greater value than your initial property.
Cover all your bases by consulting with a tax advisor about your personal financial circumstances. Separately, consult with a QI regarding your exchange to ensure you are on the right path. QIs work specifically with 1031 exchanges and are experienced with their nuanced applications.
The 1031 Investor. “Can You Take Money Out of A 1031 Exchange?” http://www.the1031investor.com/can-you-take-money-out-of-a-1031-exchange/. Accessed 13 January 2018.
The 1031 Investor. “Equal or Up.” http://www.the1031investor.com/equal-or-up/. Accessed 13 January 2018.
BiggerPockets. “The 1031 Exchange Ultimate Guide for Real Estate Investors.” https://www.biggerpockets.com/blog/2015/09/24/1031-exchanges-real-estate/. Accessed 13 January 2018
Realty Exchange Corporation. “Exchange Reinvestment Requirements.” http://www.1031.us/wp-content/uploads/ReinvestmentRequirements.pdf. Accessed 13 January 2018.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.