The IRC Section 1031 Exchange is a tax provision that enables investors to defer capital gains tax on the sale of investment real estate or real estate held for business purposes. To qualify for tax deferral, the taxpayer must reinvest the net proceeds into ‘like-kind’ business or investment real estate.  

In addition to its financial advantages, the 1031 exchange is a valuable tool that can be used to achieve various objectives. Often, market factors, asset quality, returns, or strategic planning drive exchange transactions, impacting eligibility and offering additional benefits and considerations for investors. 

Is any type of real estate held for business or investment eligible in a 1031 exchange? Yes!  

Many people associate 1031 exchanges with commercial real estate, but its benefits are available to any taxpayer selling non-owner-occupied real estate, whether it’s held for investment or for productive use in a trade or business. Hence, even rental real estate properties are eligible for an exchange if the intent and holding periods are met. 

Why 1031?

By selling outdated or costly-to-maintain properties and reinvesting the proceeds into properties aligned with your updated portfolio goals, you can enhance cash flow and profitability. 

A 1031 exchange consists of purchasing an investment property and then selling it within 180 days —without triggering capital gains taxes. 

In essence, when you sell a profitable investment property (the ‘old’ property), you can use the sale proceeds to acquire another similar investment property without paying capital gains taxes on the profit. 

Under the tax code, it is possible to sell one piece of real estate and reinvest the proceeds into another like-kind property (like-kind refers to properties that are similar or comparable, such as beachfront homes but not condos).  

And while expenses from the initial sale may not be deductible, you can defer taxes on any profits until the subsequent year. 

Moreover, if you later sell the second property at a higher price than your purchase price, you’ll receive a step-up in basis for capital gains purposes. 

Implementing this strategy can safeguard the equity you’ve diligently built over your investment journey. 

What are the rules? 

The rules surrounding a 1031 exchange are complex and different from general tax regulations, and are applicable to vacation homes, Airbnbs, and secondary residences. These differ from primary residences and vacation homes due to depreciation regulations that safeguard the value of primary residences (i.e., you cannot depreciate a secondary home). 

Primary Residence: When selling your primary residence to acquire another, any capital gains taxes are deferred until the eventual sale. This also applies to vacation homes or Airbnb properties. 

Vacation Home/Airbnb: If you are selling a vacation home or Airbnb property to acquire another property for rental purposes: no capital gain is realized upon selling your former property; however, there are tax implications if you sell before utilizing all its depreciation deductions. 

If the property is not used for rental purposes within two years, only 50% of the depreciated basis can be deducted from income taxes; and if it is used for rental purposes, 100% can be deducted from income taxes upon sale at fair market value. This means some individuals might benefit financially from purchasing a more expensive house that has been on the market for an extended period, as it would qualify under the fair market value rule, allowing them to deduct the full purchase price rather than the depreciated basis originally paid 

Time requirements 

The IRS imposes strict requirements for 1031 exchanges, including: 

• Holding Period Requirements: You must own the original property for at least 24 months before selling it; failing to meet this requirement will result in taxes being due on any gains realized upon sale. 
• Purchase Period Requirements: If you intend to use your 1031 Exchange funds to purchase a new property, it must be acquired within 45 days of selling your old property (often requiring you to purchase it before closing on the old property). 
• Sale and Purchase Completion Timeline: Both the sale of the old property and the purchase of the new property must be completed within 180 days from the closing date of either property (unless an exception applies). 

What are the advantages of 1031 Tax-Deferred Exchanges?

Leverage 

Investors can utilize the 1031 tax-deferred exchange to acquire higher-value investment properties. By redirecting the funds that would have been paid to the IRS in taxes, investors can enhance their down payment and expand their purchasing capability to acquire a more valuable replacement property. This strategy allows investors to leverage their cash effectively, fostering continued wealth accumulation through real estate investment. 

Diversification by market or by asset type 

If you own real estate only in a single market or geographic area or you own several investments of the same asset type, it can be risky. However, you can utilize the 1031 exchange to diversify your market areas or asset types, to reduce any potential risk. 

Consolidation 

Owning different properties can help mitigating administrative and maintenance responsibilities. Have you thought of the potential liabilities? Windows, roofs and every other item that the investor is responsible for maintaining? 

Management and quality of life 

How much time does it take? Owning a large rental property with several units can be intense to manage. And even after many years many multifamily owners get sick of the “Four Ts”: tenants, toilets, termites, and trash. Therefore, investors end up utilizing the 1031 exchange to acquire replacement properties that are subject to long-term net leases. These leases typically transfer most or all maintenance responsibilities to the tenants, ensuring predictable and consistent rental cash flow, along with potential for equity growth over time. 

Build your Portfolio 

Through a 1031 exchange, untaxed funds are utilized to acquire replacement real estate. This empowers investors to procure replacement property using funds that would have otherwise been allocated to capital gains tax upon property sale. This approach enables investors to potentially amplify their purchasing capability and wealth accumulation prospects. What’s more, increased equity may result in a reduced loan-to-value ratio, facilitating approval for acquiring higher-value properties. Employed as a long-term tactic, a 1031 exchange can be iterated continuously and integrated with other tax-efficient strategies to nurture a diversified portfolio. 

Increased purchasing power: 

Let’s consider the financial impact of a 1031 exchange using the following numbers: 

Capital gains are taxed at a maximum rate of 20%, and depreciation recapture is taxed at 25% for individual taxpayers. In this example, the total taxes due would amount to $76,750 (25% of $35,000 for depreciation recapture and 20% of $340,000 for capital gains). Furthermore, many states impose a state capital gains tax that can be deferred through a 1031 exchange, providing investors with enhanced purchasing power 

If the investor chooses to purchase a new property with all cash, they would have an additional $76,750 available to reinvest through a 1031 tax-deferred exchange. Alternatively, if the investor decides to obtain a loan and the lender mandates a 60% loan-to-value ratio, the potential values of a replacement property would be as follows: 

Using the cash as leverage, the investor has an additional $127,917 of purchasing power. 

Relocation 

Investors or businesses can utilize a 1031 Exchange to relocate investments to different locations for various reasons, such as retiring to another state, job transfers, accessing more favorable markets or lower local taxes, or leveraging local business incentives. 

Cash Flow Improvement 

Investors can employ a 1031 Exchange to transfer accumulated equity into higher-performing assets without triggering immediate tax liabilities from the sale. 

Planning 

The ability to continually exchange real estate over a lifetime allows for ongoing deferral of capital gains tax and basis transfer to subsequent properties until the taxpayer’s passing. Upon inheritance, heirs receive a ‘stepped-up’ basis —typically defined as the fair market value at the time of death— thereby potentially eliminating significant capital gains liability permanently with proper planning. Furthermore, utilizing an exchange, investors can potentially sell and distribute a large property into several smaller properties for each heir, while minimizing capital gains tax implications. 

Conclusion

Both new and experienced investors leverage the benefits of the 1031 tax-deferred exchange. Given the economic growth and property appreciation witnessed in numerous areas across the country in recent years, it presents a compelling opportunity. In addition to significantly boosting purchasing power, a 1031 exchange offers advantages such as leverage, consolidation, diversification, relief from management responsibilities, and increased cash flow and income. 

Don’t miss out on the filing deadline! 2024 tax season ends in April 15th. Our team is available to help you with your taxes and every concern you may have about your business. Join us any Friday and gain insights of the overall offering, system, and support that Real Estate IQ and partner firms render. It is a starting point for inspired real estate deal makers and serious business entrepreneurs to exchange critical information and resources. Let us assist you with your inquiries to maximize your savings and profits! 

Disclaimer: The blog articles are intended for educational and informational purposes only. Nothing in the content is designed to be legal or financial advice.