A 1031 Exchange (or “like-kind exchange”) allows real estate investors to defer their capital gains taxes (and other income taxes) when selling a property. Investors must reinvest in another qualified asset. The strategy comes from Section 1031 of the Internal Revenue Code.
In other words:
A 1031 exchange is an asset-swap that goes unrecognized for tax purposes.
(The IRS calls this “nonrecognition of gain or loss“)
Put into practice, a 1031 exchange is a powerful wealth-building tool. And it’s a key weapon in any real estate investor’s arsenal.
Here’s an example of what we mean:
Let’s say you sell a rental property at a gain.
In a normal sale with $200,000 gain, you would owe $40,000 or more in capital gains tax.
But with a 1031, you allow your wealth to snowball.
Money that otherwise would have gone to the IRS as taxes now goes as down payment on your new property.
So you can now afford
higher income properties
to switch to a different class or sector
After just one 1031 exchange, the extra money you keep makes a big difference.
And allows much greater return on your cash.
Over an investing career, this strategy can completely transform your real estate portfolio.
As our founder and attorney Steven W. Hickox puts it:
I like to think of a 1031 exchange as an interest-free loan from the government. That’s its real strength.
Key takeaway: The 1031 “like-kind” exchange allows real estate investors to delay taxes and boost returns, especially over the long term.
Why Do a 1031 Exchange?
Let’s follow that (silly) snowball analogy:
You make a snowball and roll it downhill.
The snowball gets bigger as it rolls.
Unfortunately, there are sharp rocks at the bottom.
(Quick fact: Income taxes are often your largest cost when selling investment real estate)
But what if you could put your snowball on top of a new hill instead of hitting the rocks?
That snowball keeps growing bigger, faster.
You get the point.
1031 exchanges do this for your real estate investments.
You’ll hurdle right over HUGE tax events.
And get tons of benefits.
Like-kind exchanges help you defer taxes so you can keep your gains working for you.
(We’ll show you how later)
No tax bill.
Your “snowball” just keeps growing!
How Does a 1031 Work?
Fundamentally, an exchange creates legal distance between you (the taxpayer) and the results of your transaction (receiving taxable proceeds).
To accomplish this, your transaction must be structured as an exchange, rather than as asale.
When you perform the exchange — and follow the many exchange rules, including reinvesting properly — you get to defer your tax bill.
(And, in some cases, you can completely avoid paying certain taxes)
So which taxes (and how much) can you defer?
Here’s a snapshot:
In most cases, investors face three taxes upon sale.
Capital Gains Tax
Depreciation Recapture Tax
Obamacare Tax (ACA or NIIT)
Let’s review those individually.
Capital Gains Tax
When you sell an investment property, you are taxed on the difference between your tax basis…
You purchase a rental property for $250,000 (your basis).
You later sell for $315,000, but pay $15,000 in closing costs.
The net difference ($50,000) is your capital gain.
Both the IRS and (most) state governments tax your capital gains when you sell.
(Of course, capital gains taxes aren’t unique to real estate. The government also taxes gains on stocks, bonds, coins, art, jewelry, etc)
Depreciation Recapture Tax
Investors get to “depreciate” — that is, gradually deduct from their taxes — the cost basis of their real estate. In effect, depreciation lowers your tax bill each year.
How much you can deduct depends on the type:
Residential – evenly depreciates across 27.5 years
(about 3.64% each year)
Commercial – evenly depreciates across 39 years
(about 2.56% each year)
It’s a huge advantage to owning real estate.
But the IRS doesn’t leave it at that.
Whenever you sell your investment real estate, you have to tabulate all of your prior deprecation and then pay taxes on that amount. This “depreciation recapture” tax rate is normally 25%. (If you depreciate a building by $100K before you sell, then you’ll owe the government $25K upon its sale)
For many exchangers, this is the single largest sale cost item.
Thankfully, a successful 1031 exchange defers these taxes as well.
“Obamacare” or NIIT Tax
The Patient Protection and Affordable Care Act (i.e. “ACA” or “Obamacare”) passed in 2010. It’s many provisions phased in over the course of the next 3.5 years.
One of those provisions was a brand new tax on investments.