The Power of a 1031 Exchange

July 3, 2020
July 3, 2020 disrupt

The Power of a 1031 Exchange9 min read

What is a 1031 Exchange?

A 1031 exchange can be one of the most useful sections of the IRS tax code when understood properly and leveraged to your advantage.

“Section 1031” of the IRS tax code is the magical code that allows business owners/investors to avoid (more technically “defer”) paying taxes in the short term.

This essentially is a swap of one business or investment for a like-kind asset. In nearly every scenario, an owner is taxed on the sale of one product in order to buy another product.

However, when one utilizes the IRS Tax Code “Section 1031”, the sale of one asset and purchase of a like-kind asset is not taxed immediately.

This is because the capital gains are not realized at time of sell and therefore deferred until the second property is sold.

This section of the tax code doesn’t provide any limitation to the number of usages, which means the second asset could then repeat the process and perform a 1031 exchange towards the next (third) asset.

As one could imagine, when an owner can defer taxes on an asset, and then repeat the cycle deferring the capital gains taxes without limitation, there is a very powerful tool at hand to use.

Let’s dive deeper into the restrictions and qualifications when using a 1031 exchange.

1031 Exchange is the Holy Grail of Real Estate

For the purpose of this article, we will use the power of the 1031 exchange regarding real estate assets. This can be the holy grail of real estate if used effectively since there is not a limit to the number of times an owner can use a 1031 exchange and therefore continue to defer taxes indefinitely.

A few key points to recognize is that this cannot be used for personal use, meaning that one could not exchange their primary residence for another house (vacation homes have a few loopholes).

In order to perform a 1031 exchange in real estate, it must be for a like-kind property. The term “like-kind” is a very vague and broad term since one could exchange undeveloped land for a shopping center or even a mobile home park for a brand-new apartment building.

Therefore, it is important to consult with a commercial real estate attorney and tax professional before launching into unfamiliar territory.

Another important concept is the “delayed” exchange. When swapping a property for one that is like-kind, very rarely are they the exact same price, in fact almost never.

This would then create a delta in price, and one must be very careful on how this deficit is handled in order to not default on the qualifications for the 1031 exchange.

Every penny of the sell from the first property must be held in escrow until the second (or “replacement”) property is fully closed.

If any profit from the sale of the first property is captured, then you will be taxes and may forfeit the qualifications for a 1031 exchange.

So long as the entirety of the proceeds from the sale of the first property is held in escrow and closed within the proper time restrictions, then you’ll have either very little or no taxes to pay at the time of exchange.

These will roll over into the next property and will be paid at the time of sale for that property (unless you perform another 1031 exchange).

After the exchange is completed, if there are any left-over profits, this is referred to as the “boot” and this portion would be taxed as regular income.

When to Use a 1031 Exchange (Timeline & Restrictions)

Next you might be asking after finding a like-kind property, what are the time restrictions in order to qualify for a 1031 exchange?

That’s an excellent question, and one to be cognizant of when researching the replacement property. When property number one is sold then 100% of proceeds must be immediately placed into escrow, and within 45 days the replacement property must be designated.

This means that you must provide in writing to the 1031 exchange intermediary the exact property you are intending to perform the exchange before the end of the 45th day of the original sale.

It is possible to designate more than one replacement property; in fact, you may select up to three so long as close on one of them before the second mandated timeframe which is 180 days.

In some scenarios, it possible to designate more than three properties with the major limiting factor restricting to not exceed double the market value of all exchanged properties.

The second most important time range is the 180th day from the original sale, which is the deadline for closing on the replacement property.

The 1031 exchange will be forfeited if the replacement property is not closed within 180 days from the sale of the first property.

It’s important to keep in mind that the first 45 days is concurrent and included within the 180 days.

These two deadlines of 45 days to designate the replacement property and 180 days to close on the replacement property are hard deadlines without any type of extensions.

Does a 1031 Exchange Avoid Paying Taxes and Other Similar Terms?

Assuming you meet both deadlines, is it possible to sell a property and not pay any taxes? In the short term, yes; but more accurately, you’re deferring the taxes until the sale of the property.

Let’s use an example, when a $1,000,000 property is purchased and then years later sold, it could be used as a 1031 if all regulations and deadlines are appropriately followed.

This 1031 exchange must have a designated replacement property on or before the 45th day and then closed on or before the 180th day.

Once both requirements are met, you now own the second property and you did not take a single penny of the profits from the first property, then you wouldn’t pay taxes either.

The clarification is that you’re not avoiding taxes, you’ve just deferred them. This means that when you sell the second property, at that time you must either pay the taxes or 1031 exchange once more.

This cycle may continue using 1031 exchanges without limit, however, the first time you take a thin dime of financial proceeds, you will certainly pay taxes.

Within this same realm of tax deferred opportunities, I would be remiss to not mention the 1031 Delaware Statutory Trust and Opportunity Zones.

The 1031 Delaware Statutory Trust (DST) provides an opportunity for investors to receive monthly income without any major landlord responsibilities.

A key point to note would be that these 1031 DST’s are illiquid, and the investor loses all control and decision-making authority ranging from anything a small as painting the front office of the property or as large as when to sell.

Opportunity zones are a strong contender to give the 1031 a run for its money. Opportunity zones allow the investor to not only reduce or defer their taxes, but the possibility to owe zero capital gains tax whatsoever.

A few differences would be a clear deadline of deferring until April 2027 rather than the indefinite 1031 exchange, the potential of up to 15% capital gains reduction with OZ’s unlike 1031 exchanges, and the investor can assume to pay zero capital gains taxes on any appreciation upon final sale whereas the 1031 the investor is taxes on the final sale.

Here’s How You Utilize a 1031 Exchange

Do you own a rental home, four-plex, or even a small apartment?

Let’s assume the scenario for most Americans, you own a home that you’ve been paying on for the better part of a decade, you’ve put a sizeable down payment, consistent yearly debt paydown, and we’ll use $200,000 as the original purchase price.

If you wanted to 1031 exchange this home, you would first have to convert it to an investment property since a personal home cannot be used as a 1031 exchange.

You must move out of the property, move a tenant into the house, and prove rental income for a minimum of 2-3 years at market rate.

If you can prove you lived somewhere else and the property was rented out at reasonable market rate to a tenant, then this would most likely qualify as an investment property and therefore become eligible for a 1031 exchange.

At this point you can reap all the incredible tax benefits on your own (investment) home. In this scenario, let’s assume the property has now increase to $300,000 in value, the capital gains of $100,000 which would normally be taxed at a high rate, is now deferred and increase the value rolled over into the replacement property.

This will increase buying power and allows the investor to snowball the financial momentum into the future.

Don’t Avoid Taxes, Just Defer Them!

The IRS Tax Code Section 1031 is commonly known, used, and quoted by investors in the industry.

It’s important to keep in mind the 45-day identification window and the 180-day closing window for the replacement property so that your 1031 exchange isn’t disqualified.

When this is performed for a like-kind property, the tax advantages are exceptional.

For the long-term investor, this can strengthen his financial buying power, enhance the size of his portfolio, and allow for the acquisition of larger assets by deferring the taxes into the future indefinitely.

While it’s catchy and attractive to say that you are avoiding taxes, just keep in mind you are more appropriately “deferring” the capital gains taxes.

With a 1031 exchange, the investor will pay taxes on the final sale. The power of the 1031 exchange becomes even more potent when utilized on larger commercial properties like apartment buildings, retail centers, office space, etc.

If you are impressed by the tax benefits on the real-life example mentioned above for your house, imagine the power when there are a few zeros added to the purchase price and therefore a few zeros in the tax benefits too!

The ability to strategically defer taxes and pay them at the most advantageous time for the investor is a key tool to use and implement in the financial repertoire.

Never forget the wise words from Winston Churchill, “For a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.”

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