Heard of 1031 exchanges, but not entirely sure how they work? Mystery may be intriguing, but it never saved anyone money on their taxes; 1031 exchanges refer to Section 1031 of the IRS tax code, which allows real estate investors to defer paying taxes on capital gains from real estate sales, if they invest their profits in a “like-kind” investment.
Before going further, here’s a concrete example to work with: Kelly has owned a rental property for several years, and sells it this year for a profit of $50,000. The IRS 1031 exchange rule allows her to use that $50,000 to buy another investment property, and defer the taxes she would owe on that $50,000 capital gain.
A few definitions are in order, as tax lingo grows esoteric quickly. To “defer” one’s tax liability is to postpone it to an indefinite later date; in this case, instead of owing taxes on her $50,000 profit from the property sold this year, Kelly will owe taxes on her profits later when she sells the new property (in tax lingo, it changes the “basis” in her new property purchase).
Another necessary definition is “like-kind”: 1031 exchanges only allow like-kind property to be exchanged, and in real estate this means investment or business-use properties (e.g. rental properties, office space, retail space, etc). Primary residences, second homes and international properties cannot be 1031 exchanged. Also allowed to be exchanged is personal property (e.g. cars used for business purposes), but again they must be like-kind and not exchanged for a different type of asset (for example, proceeds from the sale of an rental property cannot be exchanged to buy a business-use car – only proceeds from the sale of a business-use car can be exchanged to buy a new business-use car). Paper assets (e.g. stocks, bonds, etc) are specifically excluded and cannot be used in 1031 exchanges.
Unfortunately, executing a 1031 exchange is not as easy as Kelly simply jotting a note on her tax return saying “By the way I 1031-exchanged these two properties, don’t charge me for taxes.” First, Kelly must go through an intermediary or “exchange facilitator” who holds funds and keeps written records of both transactions. Kelly cannot act as her own intermediary, nor can an employee of hers, or her real estate agent, accountant or attorney. When she sells the old property, she must notify her intermediary in writing of her intent to purchase the new property within 45 days, and must complete the transaction (settle on the new property) within 180 days.
Upon filing her tax return, Kelly must also fill out IRS Form 8824 and include it in her return.
So why is this useful, if it adds complexity and Kelly will still owe taxes eventually? Because that tax bill may never come due, and because Kelly can use the money to continue investing and growing in the meantime. Kelly may decide never to sell the new property, in which case she will never have to pay capital gains on the original $50,000 profit. Or perhaps when she does decide to sell it three years later, she simply does another 1031 exchange to purchase an even larger property at that time (e.g. a large multi-unit building with strong monthly cashflow), and further defers her tax bill indefinitely. And even a worst-case scenario in which she does end up paying the full tax amount a few years from now, she has effectively borrowed money from the government at 0% interest – a win-win scenario for her.
This ability to roll over her profits without paying taxes is an incredible advantage for Kelly to continue expanding her rental portfolio: if she lives in California and pays the highest tax bracket, she would owe 37.1% of that $50,000 in capital gains taxes ($18,550). If Kelly wants to invest in a new rental building, she would have $31,450 to invest, instead of $50,000 – say her financing is at 75% LTV and she must come up with the other 25% as a down payment, she could only afford to buy a $125,800 property instead of a $200,000 property.
That’s a very real difference in buying power, the difference between a savvy investor and a novice.