Real estate is the investment of choice for many because it is one of the few asset classes that enjoy favorable tax treatment. Reducing your taxes is an important part of building your net worth, and a Section 1031 exchange is one of many great real estate tax strategies to do just that.
If done correctly, it allows a real estate investor to avoid paying a capital gains tax. Admittedly, the idea of avoiding taxes strikes fear in the average law-abiding citizen. Most remember Lauryn Hill and Wesley Snipes‘s unfortunate run-ins with the IRS and their subsequent jail time.
However, there’s a difference between tax evasion (Lauryn and Wesley) and tax avoidance. Tax evasion is the illegal non-payment or underpayment of taxes while tax avoidance is the arrangement of one’s affairs to minimize tax liability. A Section 1031 exchange is the latter.
Typically, when a real estate investor sells an investment property, he or she is required to pay taxes on the gain at the time of the sale.
Example: Investor purchased a duplex in 2014 for $150,000. In 2018, Investor sells the property for $250,000. The investor is required to report her capital gain of $100,000 on her 2018 tax return, which could result in a tax liability of up to $20,000.
However, the US tax code provides, “[n]o gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment (emphasis added).” 26 U.S.C. 1031(a)(1). In simple terms, the Section 1031 exchange, commonly known as a “like-kind exchange,” allows an investor to defer the payment of taxes on the sale of a property by using the proceeds of the sale to purchase another property.
Example: Investor purchased a duplex in 2014 for $150,000. In 2018, Investor sells the duplex (“relinquished property”) for $250,000 and purchases a single family investment property (“replacement property”) for $250,000 as part of a properly executed 1031 exchange. The investor does not realize the $100,000 capital gain and therefore has no tax liability.
In this case, deferring tax liability has huge benefits. Instead of paying $20,000 in taxes, there is more money to acquire a more expensive property with potentially more investment benefits such as increased rental payments. If you decide to sell the properties in retirement, you could pay less in taxes because you might be in a lower tax bracket in retirement. However, you aren’t ever required to sell and can pass significant tax savings on to your children.
As an investor, there are five key points that you should know about 1031 exchanges.
1. Property held for investment
The key point is that the property must be an investment. It cannot be a personal residence. There are some cases where a primary residence has been converted into a rental and could qualify. However, merely saying the property is a rental is not enough. The owner cannot live in the property, and the property must be rented to a third party for some time. It also cannot be property that is held for sale, a.k.a “a flip.”
2. Property must be “like kind” a.k.a “similar”
The meaning of “like kind” property is surprisingly liberal.
One hard line is that property located outside of the United States is not “like kind” to property inside of the United States. Beyond that, the law only requires “that the properties are substantially alike.” To illustrate the extent of the law’s seemingly liberal definition, the tax court has determined that city real estate is “substantially alike” to a farm and that mineral rights are “substantially alike” to land.
3. If the tax code giveth, then the tax code can taketh away
When the tax code provides a tax benefit, taxpayers must strictly adhere to all of the rules and regulations or the benefits are lost from this real estate tax strategy. Although the exchange of the properties does not have to be simultaneous, there is a timeline that must be followed. Think of the “like-kind” exchange as a six-month-long transaction with two important deadlines. If these deadlines are not met, the transaction is destroyed, and the gain from the sale of the relinquished property is taxable.
The first deadline is the identification of the new property (“replacement property”). This must be completed within 45 calendar days of the sale of the exchanged property (“relinquished property”). The second deadline is the receipt of the replacement property, which must be completed no later than 180 days after the sale of the relinquished property or the due date (including extensions) of the income tax return in which the property was sold, whichever is earlier.
The replacement property does not have to be the exact property identified during the 45-day identification period, but it must be substantially similar.
4. Signed, sealed, delivered
There is significant guidance on the identification of replacement property. IRS guidelines require three things in the written document or agreement. First, the replacement property must be “unambiguously described.” Fortunately, there’s a bit of leeway with the description. It does not need to be the property’s legal description, but it at least has to be specific enough to be related to the property. A street address is usually acceptable.
Additionally, the investor can identify more than just one property. There are two methods to determine the number of properties that can be identified. If the investor uses the fair market value method, then the combined fair market value of the replacement properties identified cannot exceed 200% of the relinquished property. If the investor does not use the fair market value, then three properties can be identified.
The second requirement is that the written document or agreement is signed by the investor. The third requirement is that the agreement is delivered to either the person obligated to transfer the replacement property or another third party involved within 45 calendar days after the sale of the relinquished property.
5. Don’t do this alone
The complicated nature of this transaction requires professional assistance. “An experienced [real estate] agent is the front-line resource for buyers and sellers to cut timeframes of project deadlines,” says Traci Powell, a Philadelphia based real estate agent for investors. “An experienced agent knows all of the contracts and real estate law associated with each type of real estate transaction needed for the county and state they are doing business.” A 1031 exchange also requires that a qualified intermediary receive the funds. Most qualified intermediaries also process and monitor the paperwork necessary for the transaction. As in most tax-deferred transactions, no money involved in the transaction can be made available to the investor. If it does, it is considered “constructive receipt of funds,” the transaction is destroyed and the gain is taxable.
Things to remember
Section 1031 exchanges are an advanced real estate investor tactic, but they can be worth thousands in saved taxes if done correctly. Even if you aren’t investing in real estate now, it’s knowledge that may help you in the future.
Being a successful investor requires that you know and play by the rules. Everyone who invests, or is considering investing in real estate, should understand the concept of tax deferral using the 1031 exchange. Tax deferral is arguably the most important tool in your wealth accumulation and preservation toolbox. Postponing the payment of taxes on investment gains allows more money to compound which over time can result in higher long-term returns.
Beware unscrupulous individuals and companies promoting the improper use of 1031 exchanges. For example, some companies promote 1031 exchanges as “tax-free” exchanges (never paying taxes) instead of “tax-deferred” (putting off taxes to another time) exchanges. Additionally, some companies encourage investors to claim a 1031 exchange even after the investor received money in hand from a sale. Just be mindful of any “too good to be true” deals because they probably are.
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Courtney is a former Financial and Investment Advisor for one of the top brokerage houses on Wall Street. In 2014, she started The Ivy Investor, a blog focused on explaining investing, retirement, and wealth concepts in simple terms. Courtney is the epitome of a buy and hold investor. But she, like many others, has caught the cryptocurrency bug. Courtney holds a J.D. from West Virginia University College of Law and an LL.M. (Master of Laws) in Taxation from Temple University Beasley School of Law with a certificate in Estate Planning.