Business Management

How to Build Wealth Now, Pay Taxes Later with a 1031 Exchange

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real estate, 1031 exchange, investment property

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.

Related: The 1031 Exchange Ultimate Guide for Real Estate Investors

property, for sale, real estate, investment, reinvestment

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.)

Related: The Ultimate Guide to Real Estate Investment Tax Benefits

Sell Then Reinvest

Once you decide to move forward, the steps to defer all tax using a basic 1031 exchange are pretty straightforward.

  1. Sell your investment property using a qualified intermediary (QI) to document the process and ensure the transfer of proceeds.
  2. 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:

  1. 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.
  2. 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.

investment property, reinvestment, 1031 exchange, calculator

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.

NET CASH

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)

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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.

Conclusion

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.

References

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.

Thinking of applying this tax strategy? Or have you successfully completed a 1031 exchange?

Share your experience below!

Dave Foster, real estate investor and qualified intermediary, has 20 years of experience working in all phases of real estate investing, from large scale development to single family homes and vacation rentals. This experience has given him a keen eye for opportunity and a clear vision for reducing the impact of taxes. A degreed accountant with a Master’s in management, Dave is Regional Director for Exchange Resource Group and has recently launched his own educational website, The 1031 Investor. Dave has built his reputation on being a driven, results-oriented 1031 Exchange Qualified Intermediary who works relentlessly to maximize value for the real estate investors he works with. He has taught numerous certified continuing educations courses on investment tax strategies. His particular focus on basic and advanced 1031 exchange topics has made him a popular guest speaker for local realtor associations, investment clubs, and podcasts. He teaches agents, investors, and advisors alike the ins and outs of 1031 exchanges and other tax and investment options.

    John Lamb Rental Property Investor from Phoenix, AZ
    Replied 8 months ago
    In addition to what was mentioned in the article, isn’t there also a requirement about the time period you have to complete the new purchase and don’t you have to identify the specific property you plan on purchasing before you even start the 1031 exchange process?
    Dave Foster
    Replied 7 months ago
    That’s correct John. From the date of the closing of your sale you have 45 days to identify your potential acquisitions. And you have 180 days from the closing of your sale to complete your exchange. You don’t have to already have your replacement lined up. You do have 45 days after the start of your exchange. But It’s always a good idea to work as quickly as you can. And if you do find your replacement property before your old property closes it is fine to put it under contract. You just can’t take title until your old property closes.
    Eladio Perez
    Replied 7 months ago
    So in the example if a single dollar is taken out, do you taxes on that dollar or on the whole amount?
    Dave Foster
    Replied 7 months ago
    HI Eladio, No. You would only be taxed on that dollar you took out. the rest of the profit would still be deferred in your 1031 exchange. When you purchase less than you sell or when you take cash out you are only taxed on the difference. Reply Report comment
    Dave Foster
    Replied 7 months ago
    HI Eladio, No. You would only be taxed on that dollar you took out. the rest of the profit would still be deferred in your 1031 exchange. When you purchase less than you sell or when you take cash out you are only taxed on the difference.
    Jon Pierre
    Replied 5 months ago
    How long do I need to own a property before being able to sell it and apply the 1031 exchange? I have been told the IRS does not allow for “Flipped Properties” to be used, but if I use them as rentals then how long would I need to hold them to sell using the 1031 exchange?
    Dave Foster Specialist from St. Petersburg, FL
    Replied 5 months ago
    Hi Jon, That’s correct. If your intent in purchasing a property is primarily resale (a fix n flip) then the property does not qualify for 1031. Property eligible for 1031 exchanges is property you purchased with the intent to hold for productive use. There is no statutory holding period. It is only your intent and how you can demonstrate it. Most folks feel comfortable at anything more than one year. But there could always be circumstances where a shorter (or longer) hold might be appropriate.
    Ivan Lopez
    Replied 5 months ago
    Thanks for sharing your knowledge on this topic Jon. We have the following situation, bought a house and lived it for 3+ years, then rented for 6+ years. Now we bought another house on another state and we’re considering selling our previous house/home using the 1031 exchange method. My question is, is this house now considered an “investment property” since it hasn’t been our primary house for the last 6+ years? And if so, I’m assuming it does qualify for a 1031. Am I correct? Please advise and thanks in advance!
    Dave Foster Specialist from St. Petersburg, FL
    Replied 5 months ago
    Hi Ivan, It’s pretty safe to say that your old primary residence has been fully converted to investment status and would be eligible for a 1031 exchange. It’s been over 6 years and you have a demonstrated intent of investment use. There is no statutory holding period to qualify a property for a 1031 but there is a safe harbor given by the IRS in Rev Proc 2008-16 at 2 years with a couple of caveats. Your 1031 looks good.