Most investment property owners have heard of a 1031 exchange, but many might not know what it is or its significance. That’s understandable, seeing as 1031 exchanges are only relevant when investors are thinking about selling investment property.
If you’re ready to sell an investment property, it’s imperative to understand the ins and outs of a 1031 exchange because using this vehicle can save you a lot of money in taxes.
To help you better understand 1031 exchanges and when you would benefit by using one, we’ve asked Logan Allec, CPA, at Money Done Right. Allec specializes in taxes for real estate investors and works on 1031 exchanges on a near-weekly basis.
What Is a 1031 Exchange?
A 1031 exchange references the Internal Revenue Code 1031. It allows you to sell appreciated investment property and defer the gain on it — meaning you don’t have to pay taxes on any gain that you’ve realized on that property if you reinvest the proceeds into another investment property.
Can You Invest in Anything You Want with a 1031 Exchange?
You have to invest in like-kind property, and the definition of that is pretty broad. For example, if you sell an apartment building, you don’t have to invest only in another apartment building. You can invest in single-family homes, raw land, or even a bowling alley. A big “no-no” is reinvesting the proceeds into a primary residence because that’s not a business use.
Why Would Someone Want to do a 1031 Exchange?
Investors really like a 1031 exchange because they avoid paying taxes. The more taxes investors pay Uncle Sam, the less cash they have to reinvest. Investors want as much ability as they can to keep rolling more proceeds into more and more properties to expand their portfolio, and when there’s a tax drag on that — when a portion of their sale has to go to the government — it impedes their ability to keep expanding their portfolio.
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Why Wouldn’t You Want to Use a 1031 Exchange?
There are reasons not to do a 1031 exchange. For example, if someone’s in the lowest tax bracket of their life, they might just want to bite the bullet this year and not do a 1031 exchange — rather than down the line when they are presumably going to be in a higher tax bracket. At some point, you will pay taxes when you cash out.
Another reason someone would not want to do a 1031 exchange is if they have a loss, since there will be no capital gains to pay taxes on. Or if someone is in the 10% or 12% ordinary income tax bracket, they would not need to do a 1031 exchange because, in that case, they will be taxed at 0% on capital gains.
Finally, an investor might have another investment opportunity that’s not real estate-related. In that case, that person might prefer to pay the taxes so they can invest in that other opportunity.
Is the Capital Gain Taxed at 15%, or Is There More To It Than That?
The capital gains tax rate depends on your ordinary income tax bracket. Capital gains are taxed at 0%, 15%, or 20%. The majority of mom-and-pop real estate investors, however, will pay 15%. For example, in 2019, if you’re married and filing jointly, and you make between $78,751 and $488,850 a year, you pay a capital gains rate of 15%. Married couples who make $488,851 or more a year are taxed at 20%, and married couples who make $78,750 or less pay 0% on capital gains.
Are There Other 1031 Tax Issues to Know About?
Yes, there is recapture of depreciation to be considered. One of the great things about investing in rental property is that you get to take a deduction for depreciation, which is a non-cash deduction used against your taxable income. On the flip side, when you sell that rental property, you have to pay depreciation recapture tax at a 25% rate. But that tax, along with capital gains, can be deferred with a 1031 exchange.
Learn how one investor used the 1031 exchange to scale up his portfolio.
What Are the Most Important 1031 Exchange Rules for People to Keep in Mind?
- You can’t sell an investment property, buy another, and then initiate the 1031 exchange. You have to initiate a 1031 exchange before the property sells.
- You can’t do a 1031 exchange on your own. So if you’re thinking of doing one, the first thing to do is to find a qualified intermediary, a company that facilitates 1031 exchanges. This is not something you can DIY.
- There’s the identification period rule. Within 45 days after you sell your property (called the relinquished property) you must identify potential replacement properties.
- You have to purchase and close on the replacement property within 180 days after you sell your relinquished property.
- The property that you exchange into must be of equal or greater value than your relinquished property. If your replacement property is of less value, and you’re getting cash from the deal — called a “cash boot” — you must pay taxes on that cash.
- You can sell your investment property and invest in more than one property. You can buy three different properties, for example, if you want to. There’s no limit. If you identify more than three, there are some extra rules, which your qualified intermediary will go over with you.
- Fees vary on 1031 exchanges depending on the state, but for a standard 1031 exchange expect to pay between $800 and $1,200.
Find a New Property for Your 1031 Exchange
If you’ve decided the 1031 exchange is right for you and you’re on the hunt for a new investment property, browse properties on Realtor.com to get an idea of what’s in your range to qualify for a 1031.
As you build up your investment portfolio, Avail can help you set a competitive rent price, find great tenants, and keep track of your rental property income. Learn more about managing your properties with Avail.
