This is the mental math I did when I first heard about the notion of a 1031 exchange: (Has to do with taxes + seems like older male investors use it) x (taxes are boring/complicated) = (Makes me feel stupid/I’ll learn about it another day)
Well, people, that day has come and past! I am now quite familiar with 1031 exchanges because I have two different clients who are in the middle of them. With that said, I’ll do my best to break it down for you and take some of the mystique out of 1031 exchanges.
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Who is a 1031 Exchange Relevant For?
A 1031 exchange is mostly relevant for people with a rental property. (I’ve heard about work arounds for fix and flips and other types of properties, but that’s beyond the scope of this article.) So, back to the basics: 1031 exchange is relevant for people who want to use the proceeds from the sale of one rental property to purchase another rental property.
Why Would I Use a 1031 Exchange?
The purpose of a 1031 exchange is to defer paying 15 percent taxes on capital gains. So, if you sell a property and you’ve made some money on it, you pay 15 percent on your gains. If you defer your money by using a 1031 exchange, you don’t have to pay those taxes as long as you roll that money into another investment (rental) property. (And, yes, this is the government encouraging you to buy real estate.)*
Note on this, the taxes you could avoid paying could be as high as 30 percent when you consider depreciation costs, etc. But on the surface, it’s the 15 percent capital gains tax you are avoiding here.
How does a 1031 Exchange Work?
There’s a few important rules here:
- The rule works for like kind properties — so passive investment vehicles. You can sell a rental property for another rental property, or a one bedroom apartment for land or a duplex. It’s not necessarily about the property — it’s about the passive income you will get on the property. Simply stated, it’s real property for real property.
- From the day you sell your initial rental property, you have 45 days to find a property you wish to purchase.
- From the day you sell your initial rental property, you have 180 days to close on a new property.
- You must purchase property of equal or greater value than the adjusted value (not the price value — but the adjusted cost basis when taking into account depreciation less commissions and closing costs) of the property you sold, or you will be taxed on the difference.
- If you do not close on a property within 180 days of selling your initial property, you pay the capital gains tax on your initial property.
- During the interim of selling your first place and closing on your second, you cannot touch/look at/be near the profits from the first place you sold. That money stays with a 1031 exchange facilitator (qualified intermediary) and not, not, not with you.
- The old property and the new property must be sold and bought by the same entity. Meaning, if you sell a property as John Smith, you have to buy the new one as John Smith — and not as Smith, LLC.
- This point has been debated by the experts, but a good rule of thumb for the majority of you is this: You must own your property for one year and one day to make this 1031 exchange. Otherwise, will be penalized.
These are the basics. If you have more questions about a 1031 exchange, reach out to a 1031 facilitator, a trusted tax professional, or someone you know and respect in real estate. A lot of people are intimidated by a 1031 exchange, but it’s pretty easy. And if you are starting to dabble in real estate investing, it’s better to learn this stuff sooner rather than later. If you want a recommendation for a good 1031 facilitator (aka, a qualified intermediary) or would like to discuss more, private message me and I’m happy to discuss!
**And a special thanks to fellow, BPer, Lisa Reyna and her inner 1031 nerd — for good 1031 and tax related chats.
Do you have questions about 1031 exchanges?
Ask them below!