2 Make-or-Break Rules to Follow for a Successful 1031 Exchange
Perhaps you have heard the term 1031 or like-kind exchange, or maybe you have already gone through the process before. Either way, before you jump into your next exchange, make sure that you know how to do it and what the potential tax consequences are without a 1031 exchange.
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When it comes to rental real estate, 1031 exchanges are a great tax deferral tool. A 1031 exchange allows you to essentially “trade up” one property for another. The value of the property and the gain that you would have paid taxes on the sale are reassigned to the replacement property and may be deferred until the replacement property is sold. However, the strategy is only effective if done the right way, and unfortunately that oftentimes does not happen. Let’s take a look at some of the rules.
2 Make-or-Break Rules for a Successful 1031 Exchange
Rule 1: Trade up.
Generally, the idea of a 1031 or like-kind exchange is to move up in the world. If you have a small single family home, maybe you’re trading up for a multifamily, or if you have an apartment building you may want to trade for a commercial property. Rule #1 is that you shouldn’t be trading down. To be clear, I am not talking about the size of the property; rather, I am speaking of the purchase price of the property.
If your original property is worth $100k, then your replacement property should be higher. You’re not just limited to one property either. Recently a client of ours traded a $250k CA property for three smaller properties out of state each with a value of around $150k. In this scenario, since the value of the replacement properties totaled $450k, she had a valid exchange. If you trade down, then your exchange may not be valid and you may have to pay tax on the gain.
Rule 2: Don’t end up with boot.
This is the part that is often done incorrectly, and I have seen it happen countless times. A 1031 exchange is not a refinance. You do not want to take any money out during the transaction. Whatever cash or gain is paid out after the sale of the original property should go directly into the new property as a down payment. If the proceeds fall into your hands, then it may be considered “boot,” and it may be taxable. The IRS wrote like-kind exchange rules into the tax code in order to encourage people to reinvest. Accordingly, taking money out of the exchange defeats the purpose of their goal.
Recently a client of ours named Roger fell into this trap. He entered into a 1031 exchange to trade one single family home for another one. He had a $200k property with a $100k loan, but instead of putting his $100k proceeds into the new property, he only put in half since he wanted to use the other $50k to rehab a few other properties. By doing this, he generated a gain of $50k that was now considered boot.
Generally the boot would be taxable, but Roger was rather lucky last year in that he was able to use his real estate losses to offset the gain since he qualified as a real estate professional. Although at the end of the day he did not have to pay tax, Roger really did not take full advantage of the benefits of a 1031 exchange. He was only able to defer half of the gain.
It is important to ensure that you are working with your tax advisors on this because 1031 exchanges can be pricy. Oftentimes, you may still need to pay the exchange company even if it the exchange is done incorrectly.
Should You Consider a 1031 Exchange?
At the end of the day, a 1031 exchange is not always recommended for everyone. It is a way to defer tax and potentially eliminate taxes in the long run. Therefore, long term planning is key in deciding whether an exchange is right for you.
Perhaps if like Roger you have a large amount of real estate losses for the current year or maybe a net operating loss carrying forward from a prior year, then it may be easier to sell the property instead of exchanging. If you can afford to take the gain now, then you can save your money and do a 1031 exchange later on when it will be more beneficial. If the fair market value of your rental property is less than the purchase price, then you also may not want to do a 1031 exchange, since you would have a loss at the end of the day and would not have a gain to defer.
Related: What Investors Should Know About Qualifying As a “Real Estate Professional” For Tax Purposes
Keep in mind that not everyone is as lucky as Roger was last year. Most 1031 exchange mistakes do not have happy endings and can result in a great deal of tax. Make sure that you plan ahead and speak to your tax advisor prior to starting an exchange. Don’t wait until you’ve already started the process to let them know. Once you start the process, it may be difficult to fix it if you find out later that it will not benefit you. Planning ahead help you to avoid mistakes and take full advantage of this great opportunity to defer tax.
Investors: Any tips regarding 1031 exchanges you’d add? Any questions you have?
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