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Exchange Rules: Basics

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What is a 1031 Exchange?

What is a 1031 Exchange?

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

  • larger properties
  • higher income properties
  • more 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. “
Steven W. Hickox
Founder, 1031X

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?

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)

Not good.

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.

1031 Benefits

Bottom line?

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?

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 a sale.

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.

01

Capital Gains Tax

02

Depreciation Recapture Tax

03

Obamacare Tax (ACA or NIIT)

Capital Gains Tax

When you sell an investment property, you are taxed on the difference between your tax basis and the net-of-closing-cost sale price.

This difference is your capital gain.

Simple example:

  1. You purchase a rental property for $250,000 (your basis).
  2. You later sell for $315,000, but pay $15,000 in closing costs.
  3. 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:

  1. Residential – evenly depreciates across 27.5 years
    (about 3.64% each year)
  2. 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.

The new 3.8% tax applies to higher income levels.

This affects any taxpaying entity (individual, trust, estate, or company) that

(a) reports Net Investment Income, and

(b) crosses one of the following thresholds

You also get to defer this tax with a 1031 exchange.

Final Thoughts

Without getting lost in the weeds on individual rules, a 1031 exchange really boils down to this:

  • By creating legal distance for the investor from the sale, it delays the recognition of major taxes.
  • This delay allows the investor to reinvest an additional 20-40% (or more) of their value.

Which Properties Are Like Kind?

Which Properties Are Like Kind?

After you find your QI and sell your relinquished property, you defer your taxes by trading into “like-kind” property.

This begs a question:

What is “like-kind” property?

Fortunately, it’s really, really simple.

The answer?

Almost anything.

In fact, Section 1.1031(a)-1 of the Treasury Regulations states:

Key terms:

“productive use in a trade or business”

“or for investment”

These are pretty loose.

In fact, the regulations mostly describe what is NOT like-kind real estate.

(Personal and vacation homes, mainly)

Almost everything else counts.

The IRS’ own website is even less precise:

Like-Kind Property

Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.

Seriously. That’s it.

For instance, these are all like-kind to each other:

Life-Kind Properties

  • Single-family
  • Multi-family
  • Commercial
  • Resort
  • Farm or Ranch
  • Storage facility
  • Net-lease
  • Unimproved land
  • Water rights
  • Oil rights
  • Timber rights
  • TIC property
  • Option to purchase real estate
  • Fractional interests
  • Conservation easement
  • Termination of Tobacco quota
  • Transferable development rights
  • Delaware Statutory Trust
  • Single-family
  • Multi-family
  • Commercial
  • Resort
  • Farm or Ranch
  • Storage facility
  • Net-lease
  • Unimproved land
  • Water rights
  • Oil rights
  • Timber rights
  • TIC property
  • Option to purchase real estate
  • Fractional interests
  • Conservation easement
  • Termination of Tobacco quota
  • Transferable development rights
  • Delaware Statutory Trust

Not Like-Kind

  • Personal residence
  • 2nd home
  • Vacation home
  • Goodwill
  • Interest in a partnership
  • Foreign property <-> U.S property
  • Inventory
  • Securities
  • Debt
  • Stock-in-trade
  • Certificates of trust
  • Beneficial interests
  • Held by developer
  • Held by flipper
  • Held by dealer
  • Individual REIT shares
  • Payoff or improvements to property already owned

Important note: Partnership interests are not like-kind to real estate. That means you can’t directly trade into or out of a percentage ownership of an LLC, for example.

There are strategies for successfully trading out of partnerships or an LLC.

And they’re often specific to your situation.

Contact directly for details.

Do You Ever Pay the Taxes?

Do You Ever Pay the Taxes?

Yes…

…at least in theory. 

Example:

Sell rental ($100K capital gain )
Do a 1031 Exchange (defer taxes)
Trade into Higher-profit property
Sell new property without a 1031
Pay taxes (on gains from old and new)

The good news?

You’ll earn extra income from a higher-profit property made affordable because you did a 1031 exchange.

The bad news?

You still paid taxes.

But, what if you keep exchanging?

Trade into higher-profit property
Sell with another 1031 exchange
Trade into Higher-profit property
Rinse and repeat
Keep all of your gains

Important: A 1031 exchange is not a magic pill. It doesn’t (by itself) erase your tax liabilities. 

The IRS doesn’t let you off that easy. 

And there is a time and a place for facing a tax event.

But for lots of investors, the ability to keep all of their gains is a game-changer.

1031 Exchange Limits

1031 Exchange Limits

Let’s lightning round through a few common questions.

Important: There are many procedural restrictions during the 1031 exchange process, there is no limit on the amount of cumulative benefit that any taxpayer can receive through IRC Section 1031.

Explore More

Explore More About Exchanges

Exchange Basics
Benefits to Real Estate Investors
The Qualified Intermediary
Maximize Your Tax Benefits
Exchange Deadlines
Avoiding Taxable “Boot”
1031 Exchange Process
Advanced Strategies

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