Taxes suck, don’t they?
Sure, they pay for our roads, our schools, our bank bailouts, and our welfare system… but they are kind of the pits.
But what if I told you there was a way to make them suck a little less?
Enter: The 1031 Exchange. To a lifelong real estate investor, this little trick might completely revolutionize your business and help you save on taxes AND build significantly more wealth. This post will be your road map to make this happen.
How to Analyze a Real Estate Deal
Deal analysis is one of the best ways to learn real estate investing and it comes down to fundamental comfort in estimating expenses, rents, and cash flow. This guide will give you the knowledge you need to begin analyzing properties with confidence.
What is a 1031 Exchange?
If you decide to sell a rental property at some point, you will need to pay taxes on that gain.
Now, this might not be a big deal if you are a terrible investor or have had some bad luck and you don’t have any financial gain. But hopefully you are a smart real estate investor. You read BiggerPockets, after all. You aren’t going to make some measly profit or sell at a loss. You are going to rock this game and make some serious moolah when you sell! In short, you are going to have so much cash that you’ll need to get yourself some bigger pockets. (See what I did there!?)
But then Uncle Sam is gonna come a-knockin’ for his piece of the pie. And trust me, he’s got quite an appetite.
Don’t fret, though! I’ve got some good news: The IRS wants to partner with you on that money by allowing you to do a 1031 exchange.
Seriously? Partner? With the IRS?
Yep. Through a 1031 exchange.
A 1031 exchange (pronounced “ten thirty-one exchange” if you are cool like me), is a tax strategy so named because of its inclusion in Section 1031 of the IRS tax code. It also commonly known as a “Starker exchange” or a “Like Kind exchange.” In essence, a 1031 exchange allows an investor to “defer” paying any property taxes on the property when it is sold, as long as another “like-kind” asset is purchased using the profit received. We’ll talk about exactly what that means in just a moment, but let’s cover the big picture first.
First, understand that the 1031 exchange is NOT just for real estate, but real estate is the most common use. In reality, a person could use a 1031 exchange to defer taxes on numerous asset types, from paintings to businesses to cattle to automobiles, but seeing that this is
a real estate blog the best real estate blog on planet Earth, we’re going to focus on that aspect!
I mentioned a moment ago that the IRS wants to “partner” with you. Now, the IRS doesn’t come right out and say that, but in a way, that’s exactly what they are doing. When you make money, you need to pay taxes. But instead, if you follow the strict rules of a 1031 exchange, the IRS is basically telling you (in a whiny, nasally pitched voice, of course):
“Hey… you obviously have been doing pretty well with this real estate thing. So why don’t you hang onto our money for a while and reinvest it in your next deal? This will help you make more money next time, and we’ll get an even bigger share. Unless you want to partner again on the next one after that.”
This is what is meant by “deferred.” The taxes are still going to be due someday (unless you die, but we’ll talk about that later), but until that point, it can be extremely advantageous to keep using the government’s money to invest in properties. In addition to the government “partnering” with you, the entire US tax system is designed to encourage certain behaviors in society by rewarding or penalizing people for certain actions. In this case, the US Government is rewarding real estate investors because we are providing housing for the masses.
The logical reason for the 1031 exchange makes sense. After all, if you make $100,000 on a property and then use that $100,000 to buy another property, it’s not like you are out spending your $100,000 on shiny new toys. In fact, as we’ll discuss in a minute, the money never even touches your bank account after the sale of the property, but is held by an “intermediary.” So, the IRS in all its benevolence has decided to be fair and not require us to pay those taxes yet.
Nice guys, the IRS. Right? Well, maybe. We’ll get to that.
Even more than the tax-savings advantages, the 1031 exchange has several other benefits as well. It can allow a real estate investor to shift the focus of their investing without incurring the tax liability. For example, perhaps you are investing in properties that are low-income and thus high-maintenance. You could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. Or perhaps you want to move your investments from one location to another without the IRS knocking. The 1031 makes this possible.
Now, to illustrate how a 1031 works in the real world, let me share with you a few examples:
1031 Exchange Examples
Because 1031 exchanges can be slightly complicated, let’s look at a couple examples of BiggerPockets Members who have recently used the 1031 exchange to defer a lot of money on the sales of their real estate investments.
1031 Exchange Example #1:
In July of 2013, Jason Mak purchased an 81-unit apartment building in Riverside, CA. Paying $3.1 million dollars for the property, he immediately set out to improve the building. He worked on both the business side, evicting bad tenants and improving management efficiencies, as well as on the physical condition of the property, adding a new roof and elevator, painting, landscaping, and more. After increasing occupancy from 60% to 95% and stabilizing the entire operation, Jason sold the property for $5.5 million dollars in the spring of 2015. Overall, he netted a final profit of $2,000,000 on the two-year apartment turnaround!
Had Jason simply sold this deal, he would have needed to pay close to $600,000 in capital gains tax, but he knew better. Jason used a 1031 exchange to parlay his cash into two new properties, a 24-unit apartment building and an upscale office building. Although reducing the number of units, Jason was able to buy nicer properties in significantly better locations that will be easier to manage and increase his ability to grow wealth.
1031 Exchange Example #2:
In 2012, Serge Shukat (who we have interviewed TWICE on the BiggerPockets Podcast, episodes 60 and 131) purchased a newer single family home for $70,000, located in Casa Grande, Arizona. The home was a foreclosed property that quickly climbed in value. When Serge sold the home two years later for $135,000, he cleared almost $60,000 in profit. According to Serge, he would have had to pay close to $15,000 in capital gains tax plus an additional $3,000 or so for the recapture of depreciation. Instead, Serge spent $600 on the 1031 exchange process and was able to roll his entire profit into the purchase of a newer, larger single family home AND a 2006 mobile home on one acre of land. Essentially, he turned one $1,000 per month rental into two that gross $1,950.
When talking to Serge about this deal, he also mentioned:
“This is the most typical 1031 deal I do. I don’t sell a home via 1031 until I have first identified a replacement and then start marketing the home that has the lowest return on equity (not return on investment). This point is key. It is nearly impossible to source an adequate replacement in the short time period they give you, and the trade becomes not worthy unless you can source the replacement at a deep discount, which is rare and takes time. I’m lucky to have a pipeline of turnkey investors ready to purchase the inventory that I want to sell. I also continue to PM these homes, so add another $100 monthly to the gross transaction. When it’s all said and done, I double my gross rental income and pay no tax in the process. It’s slow going, but I’ve used this method at least 15 times and it’s an ideal way to slowly build wealth.”
Hopefully those examples helped you to see the big picture benefits of the 1031 exchange! Now, as you probably noticed in both Jason and Serge’s story, a 1031 exchange does NOT mean you are selling your property to JimBob, and JimBob is selling his property to you. I know the word “exchange” sounds like you are trading someone a pair of sneakers for his Pokemon cards, but you’re simply exchanging your property for another property (or multiple properties), though through two different individuals.
1031 Exchange Rules
If you plan to use a 1031, understand that there are some pretty strict rules that MUST be followed. If you don’t, you won’t get the tax-deferred exchange. It’s as simple as that. So let’s talk about those 1031 exchange rules now.
1. Properties Must Be “Like-Kind”
The IRS requires that the property being sold (the “relinquished” property) and the property being acquired (the “replacement” property) must be “like-kind assets.” In other words, you can’t trade a car dealership for a rental house, as they are different kinds of assets. However, you can exchange almost any type of investment real estate for any other type of investment real estate. For example:
- Exchanging a duplex for an apartment complex would be allowed.
- Exchanging a piece of raw land for a rental house would be allowed
- Exchanging a vacation rental property for a strip mall would be allowed.
Also, keep in mind that the property must be an investment, not your primary or secondary home. Additionally, both properties must reside within the United States of America to qualify.
Finally, sorry house flippers: Properties that are designed for a quick purchase and resale do not count.
2. The Replacement Property Should Be of Equal or Greater Value
In order to completely avoid paying any taxes upon the sale of your property, the IRS requires that the replacement property being acquired is of equal or greater in value than the property being relinquished, although that value could be spread out over multiple properties.
For example, let’s say you have a property that you are going to sell for $1,000,000. To get the full benefit of the 1031 exchange, you must buy at least $1,000,000’s worth of like-kind real estate through the 1031 exchange. Now, that could be a $1,000,000+ apartment complex OR four different $250,000+ properties. It doesn’t matter. (Also note: Acquisition costs, such as inspections, escrow fees, commissions, etc., DO count toward the total cost of the replacement property.)
Technically, it is possible to carry out a partial 1031 exchange and actually purchase something of lower value, but you will need to pay taxes on the difference. For example, if the relinquished property is being sold for $1,000,000 and you purchase a new property through the 1031 exchange for $900,000, you will need to pay the normal capital gains tax(es) on the $100,000 difference. This extra $100,000 is known as “boot.”
Finally, understand that when I talk about the sale price of the relinquished property, I am talking about the entire sales price, not just the profit you made. In other words, let’s say you purchased a piece of property for $100,000 and sold it later for $200,000. The replacement property would need to be greater than $200,000, not just the $100,000 in profit you made.
Now, once you have the price range understood, it’s time to start looking for the replacement property–and you better hurry up!
3. The 45-Day Identification Window
The IRS imposes a very strict timeline on identifying the property you plan to buy: 45 days.
That’s right, you must identify the property you plan to close on within 45 days or lose the entire benefit of the 1031 exchange.
Now, if you are an experienced investor, you probably recognize that this is not a lot of time to find a property, especially in today’s hot market. Sometimes I will go six months without buying a property, simply because I can’t find a deal worthy of buying! I think this is a great indication that the creators of this rule didn’t invest in real estate, but this 45 day rule is unlikely to change anytime soon, so just understand that the day you sell your relinquished property, the clock begins ticking.
Of course, you likely will have more time than just 45 days, as the timer doesn’t start until the day you sell your property. You will likely list the property for sale several months before closing, so if you are confident that you want to do a 1031 exchange, start looking for deals long before your property is officially sold. Ideally, the day that you list the property for sale can be the day you begin your search, or as in the story with Serge above, consider selling an asset using the 1031 exchange AFTER you find a new deal to purchase. Also keep in mind, you can also negotiate a long escrow period on the property you are selling, giving you more time before the countdown begins.
In addition to the countdown the IRS places on real estate investors, there are some strict procedures you must follow in this process. For example, you are allowed to officially identify three potential deals, which is helpful in case the first one doesn’t go through. If you only identify one deal and something happens later in the due diligence period, you might miss out on the entire 1031 exchange. However, while you might be thinking that you’ll just identify a ton of properties, hold your horses! The IRS generally allows you to identify up to three potential replacement properties, no more.
(There are a few exceptions to this rule, known as the 95 percent rule and the 200 percent rule. These exceptions state that you can identify more than three properties, but you are required to actually purchase 95 percent of those you identify, OR the total combined cost of all those identified properties is less than 200% of the sales price of your relinquished properties. For example, if you formally identify twenty different potential properties, you would either have to actually end up purchasing nineteen of those–95% of the twenty) or the combined value of all twenty would need to be less than 200% of your sales price. I’m sure you can imagine the difficulty in both these scenarios, but they are exceptions to the rule, though seldom used.)
Now, what exactly does it mean to “identify” a property? According to the IRS:
“The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient” (Like-Kind Exchanges Under IRC Code Section 1031).
Once the properties have been identified, it’s time to move toward closing on those properties because another timer has already begun ticking…
4. The 180-Day Closing Window
A moment ago we discussed the fact that the clock for the 45-day window starts ticking the moment the relinquished property is sold. At this same moment, another clock begins counting down as well, known as the 180-day closing window. The IRS requires that the new replacement property be fully purchased (the title officially transferred) within 180 days of the sale of the relinquished property. This rule, along with the 45-day rule, is strictly enforced, and your entire 1031 exchange will fail if you do not meet both rules.
5. No Touchy, No Touchy
Finally, one of the most important rules governing the entire 1031 exchange process is this: You may not touch the money of the relinquished property if you hope to avoid the taxes!
Although there may be up to 180 days in between the sale of the relinquished property and the purchase of the replacement property, the proceeds may never enter your bank account or an account controlled by you. Instead, you are required to use a qualified intermediary. An intermediary is someone who holds onto your money while you wait to buy the new property.
Of course, there are a lot of people out there who would love to hold onto your money for you, but I would recommend using a qualified intermediary, also known as an accommodator. There are hundreds of companies that can serve this role for you, as a quick Google search will point out. I would just recommend going with an established company that has a long history and solid reputation to avoid fraud or other unfortunate situations.
Also keep in mind, while the IRS doesn’t specifically state what a qualified intermediary is, they do define what a qualified intermediary is not. A qualified intermediary cannot be you, your agent, your broker, your spouse, your family member, your investment banker, your employee, your business associate, or anyone who has had one of these roles in the past two years (Like-Kind Exchanges Under IRC Code Section 1031).
How to Do a 1031 Exchange, Step by Step
At this point, we’ve covered all the dirty details about the 1031 exchange. Now, let’s put it all together and walk through the step by step process for carrying out a 1031 exchange. Keep in mind, the following is just a general outline, and specific deals may vary slightly from this process.
- Decide to Sell and Do a 1031 Exchange: Not every purchase is worth doing the 1031 exchange. After all, with all the requirements, costs, and countdown timers, it may be advantageous to simply pay the tax and move on. That is definitely a discussion for you and your accountant to have.
- You List Your Property For Sale: You will then list your property for sale as you ordinarily would. Your agent will likely include language in the listing paperwork regarding your desire to do a 1031 exchange and their willingness to play along.
- Begin Looking for Replacement Properties: Remember, the moment the relinquished property is sold, the countdown of 45 days begins. Therefore, begin looking for deals immediately.
- Find a Qualified Intermediary: Look for someone professional with a good reputation.
- Negotiate and Accept an Offer: When someone agrees to buy your property, you will need to make sure the paperwork clearly states that a 1031 exchange is taking place on your end, and they will need to comply. Although there is not a lot of work for the buyer to do, there may be paperwork they need to sign off on, such as assignments or disclosures.
- Close on the Sale of Your Relinquished Property: The title company or attorney will handle the closing like any other real estate transaction, except your qualified intermediary will be actively involved in the process, and the funds will transfer to their bank account, not yours.
- Identify Up to Three Properties Within 45 Days: It’s now time to officially designate the properties you might pursue. Keep in mind, you can identify up to three properties, or more if you close on 95% of them or the total combined value of the identified properties is less than 200% of the sales price of your relinquished property.
- Sign Contract on the First Choice Property: Most likely, of the three properties you identified, one will stand out as your first choice. You will need to get that property under contract and open escrow, making sure the seller knows you are purchasing through a 1031 exchange. You could also go under contract on all three of your identified properties, using contingency clauses to back out on the ones that you choose not to pursue.
- Let Your Qualified Intermediary Work With the Title Company: You, your agent, and your qualified intermediary will work with the title company or closing attorney to make sure all the i’s have been dotted and t’s have been crossed. This is actually a fairly simple process that your qualified intermediary should be familiar with
- Close on the Replacement Property: Finally, the qualified intermediary will wire over your money to the title company or attorney, and the property will close like a normal transaction, deferring your need to pay the taxes until some point in the future, if ever. (We’ll talk about the “end game” in a moment.)
The beauty of the 1031 exchange is the ability to repeat this process over and over again on properties and continue deferring taxes indefinitely. This can help you build some serious wealth over time, greater than if you simply paid the taxes each time. Let me share with you some of the greatest benefits of the 1031 exchange, starting with my favorite: faster wealth growth.
How a 1031 Exchange Can Make You Millions
Below I’m going to show you a timeline for two different investors who bought and sold properties over a thirty-five-year span. The investors in both scenarios start with the same amount of money ($50,000), buy the same property (a $250,000 deal) and have the same growth (5% equity growth each year), reinvest their profits as a 30% down payment on their next deal, but end up with a very different amount due to the taxes. Take a look. (For simplicity, we’re not including closing costs, depreciation, loan pay-down, cash flow, and other obvious sources of income and expenses in this diagram. This is simply to illustrate a point.)
Investor #1 (above) purchased a $250,000 property with his $50,000 down payment. After five years, he sold it for $319,070.39. He was able to use the entire profit–and his equity built thus far–to put a 30% down payment on his next deal. This continues for 25 years with no tax due because of the continual use of the 1031 exchange. Now let’s take a look at investor #2, who chose not to use the 1031 exchange:
After 25 years, investor #2 ended up with just under $2.5 million. While still a respectable sum of money, notice that she trails investor #1 by over $1,000,000! This is because investor #1 was able to put the government’s money to work, helping him build greater wealth.
Now, what happens at the end of year 25 to investor #1? After all, the 1031 exchange is simply a method of tax deference, not tax avoidance. Or is it? Let’s talk about that next.
The 1031 Exchange End Game
In the example above, investor #1 ended year 25 with $3.8 million, while investor #2 ended with $2.4 million. But what happens after that? Typically, there are three common scenarios for any real estate investor when they are finished with their investment career:
1. Cash Out
Some investors decide to get out of the real estate game entirely, cashing in their chips and walking out the door. In other words, they decide that they will pay the IRS what they owe after selling all their properties. However, at this point, they are not simply paying the taxes on that final property’s profit, but (put very simplistically) on ALL the properties they have ever used the 1031 exchange to avoid. Because the “cost basis” of the property is carried forward on every deal, that final tax bill will likely be exceptionally large. However, because you were able to continually use the government’s money to buy larger and larger properties, even cashing out and paying the taxes will put you far ahead of where you would have been by paying the tax each time.
However… you probably don’t want to pay that tax if you can avoid it. So let’s talk about how you are going to avoid it–forever!
2. Die and Pass it On
That’s right, many investors simply choose to hold their properties until the day that they die, passing on the properties to their heirs. The benefit of this is that current inheritance laws allow the heirs to receive the property at a “stepped up basis,” which means the tax consequences virtually disappear.
For example, let’s say the adjusted basis on a property, after numerous 1031 exchanges and lots of time, is $200,000, and the property is worth $3,000,000. If the owner sold the property five minutes before death, they would owe taxes on the $2.8 million in gain. But if the estate passes to the heirs, the basis automatically is bumped up to the fair market value, or $3,000,000. The heirs could then sell the property and pay little, if any, tax. Of course, there are special rules and fine print that accompanies this (especially for the exceptionally wealthy), so be sure to talk with a qualified professional about your estate planning!
Of course, not every investor wants to hold onto properties until they are on their death bed. I know I don’t want to be dealing with tenants when I’m 40 years old, so being a hundred-year-old landlord is absurd!
So how does one get around this?
By trading up into properties that are significantly easier to manage! For example, perhaps you could 1031-exchange your equity into a multimillion-dollar shopping mall as part of a syndication with hundreds of other investors. Or trade into a NNN lease investment, where the tenant pays EVERYTHING and you sit back and collect a check.
There are hundreds of ways to make money with real estate, so simply trading up to a more passive method sounds pretty good to me.
Final Thought on the 1031 Exchange
I’ve just spent the last 4,000 words giving you more information about a 1031 exchange than you probably ever wanted to know. You should feel proud: You now know more than 99.99% of the U.S. population! Hopefully by now you have all the knowledge needed to decide if a 1031 is right for you and if so, how to accomplish such a task.
A 1031 exchange may be slightly complicated, but the long term benefits of using this tax loophole can pack a tremendous punch in your future wealth creation and should be considered by all serious real estate investors who are in this game for the long haul. But remember, if you are considering a 1031 exchange in your future, please speak with a qualified tax professional about your options.
Questions? Comments? Feel free to ask them below. Just remember, I’m not a lawyer or CPA or qualified intermediary. You should seek professional advice with legal questions!
And if you appreciated the time I spent putting together this ultimate guide, the best way to thank me is through a social share! (You can find links to share on Twitter, Facebook, and more at the top of this page.)
(A special thanks to Keystone CPA for their help in making sure the information above is as correct as possible! Also – (The preceding is an excerpt from the new book from BiggerPockets, The Book on Rental Property Investing. If you are looking to buy more rental properties this year, pick up a copy today!)