[Editor’s Note: This is a republished post from Passive Income MD (PIMD), a member of The White Coat Investor Network. PIMD is all about finding financial freedom through creating additional income streams. The original post ran here, but if you missed it the first time, it’s new to you! Enjoy!]
The dreaded capital gains tax. Just hearing those words strikes fear into the heart of many investors. You work hard to sell a property or finally profit on an investment and Uncle Sam swoops in for his cut. It’s unfortunate, but you can’t avoid it.
… Or can you?
1031 Exchange
The 1031 Exchange is named because of where it sits in the IRS tax code (Section 1031) and it states that a taxpayer may defer recognition of capital gains and related Federal income tax liability on the exchange of certain types of property, including real estate1. What that means in simple terms is that capital gains taxes are only paid upon the sale of a property, without an exchange, otherwise these taxes are deferred.
Rules of the Exchange
Of course, there are specific rules concerning this exchange, and I would recommend having a professional assist you in setting it up. You definitely want to make sure everything is done in compliance. What are some of these rules? Well, there’s a lot, but here are the major ones:
- The properties must be of like-kind, in this case, real estate for real estate. For example, you can exchange a single family home for a multi-family property or commercial property. You can’t exchange it for a car. You can exchange for multiple properties as well.
- It must be for investment purposes and not for a quick turnaround. The 1031 isn’t intended for house “flippers.”
- The replacement property needs to be of equal or greater value in order to defer the entire gain (although you technically can exchange into a less valuable property.)
- You have 45 days after you sell your property to identify your new property/properties. You can identify up to three properties in writing and you have to end up purchasing one or more of them.
- You have to purchase the exchange property within 180 days (including the 45 day period used to identify it.)
- An intermediary has to help with this exchange meaning that all the funds need to go through a neutral party (that’s why I mentioned it should be done with professional help.)
If you break any of these rules, your sale will trigger the owing of capital gains taxes and the deferment will not take place. If you manage to follow all the rules, though, you can continue to sell and exchange indefinitely and defer those taxes until you die.
An Example
I tend to visualize better with examples, so here’s a simplified example:
In 2014, Dr. Jonas purchased a 12 unit apartment building for $1.2 million dollars in a rapidly improving part of town. He renovated the units for $100,000 and was able to demand higher rents, thereby significantly increasing the property’s net operating income.
Three years later, he was able to sell the building for $2.3 million dollars. Had he simply sold this property, he would have had to pay taxes on the $1 million dollar gain (2.3 million – 1.2 million purchase – $100,000 expense).
Instead, Dr. Jonas uses a 1031 Exchange and the proceeds to purchase a 20 unit building where he could repeat the same cycle of improve/sell and defer the taxes until he sells in the future. However, Dr. Jonas has decided to keep this building, live off the cash flow, and give it to his children when he passes on, deferring taxes indefinitely.
Sounds like a Good Deal, Doesn’t It?
“But if I do that,” I hear you say, “won’t my children inherit all those taxes?” That’s a valid concern, but not to worry.
See, the current laws allow your heirs to receive the property at a “stepped up” basis, meaning that your heirs do not “inherit” your tax burden. None of the taxes that you deferred get passed on to your children. Pretty amazing, huh? The only consideration is that estate taxes may come into play if your estate is greater than $5 million [now $11.2M and indexed to inflation, double that if married.-ed]. This situation would fall squarely into the category of a “good problem to have.”
Summary
This was just a brief introduction to the 1031 exchange, but it really highlights just one of the many tax benefits that come along with real estate investing. Used wisely, the 1031 exchange can help tremendously, not only with your own wealth creation but that of your heirs as well.
It can get quite complicated depending on your exact transaction so consulting with an experienced professional is critical.
I personally plan on using the 1031 exchange in future transactions, perhaps even with my first apartment building or even possibly through a crowdfunding platform.
Have you used a 1031 exchange before? Any other considerations that need to be made?
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I believe no. 1 & 3 are incorrect: you can purchase multiple properties & the new property can be of less value (there will just be boot). I aslo believe 4 & 5 might be misleading as you have 180 days to get the whole transaction done, not 45+180. Lastly isn’t the new estate tax exemption 10 million, if you are un married, indexed for inflation, instead of the 5 million the article mentions? Quality over quantity guys.
# 1 specifically says you can purchase multiple properties.
Re # 3: If you want to defer all of your gains, the property will typically need to be greater in value, although you can do an exchange into a lesser valued property.
Re: # 4 & 5: I can see how that might be misleading if one assumed the two time periods were separate. As stated, the statements are correct.
Re: The new exemption, you are correct that it is now higher ($11.2M, not $10M). It was not at the time of original publication of this article. We probably should have updated that prior to republication. One of the issues of outsourcing some of my editing duties. Growth is tough for any business. Thanks for letting us know. We’ll get it corrected.
quick scenario, physician A has more in his savings than what the FDIC will insure. already maxes out retirement plans, has individual investments accounts, no debt. wants to look at an option for putting the surplus in his savings above the 250 K cutoff that the FDIC will insure. wants to avoid any additional investments (real estate etc) until his social situation is more consistent. i.e. he can pick one place to live.
would you recommend putting that extra money with ally bank. they have a good yield on their savings account and also you could get that money insured with FDIC as well. it seems like a reasonable option until that doc can figure out the social part (i.e. where to settle down).
Just go to a second bank and you get another $250K limit. Or title the account differently etc. We’ve used Ally Bank as an emergency fund before. Currently, we’re using the Vanguard muni money market fund. Either of those are fine cash options.
If you want to keep it at the same bank and you are married, your FDIC limit may be up to $500k. Your bank usually has this information, and there are criteria that have to be met.
There are other ways to title the accounts too such that you can have even more protected by the FDIC at the same bank.
Agree with the above comments from Johny. In addition the last statement may also be misleading. It is my understanding that it is very difficult for a partnership to 1031x. I am sure there are some work arounds, but I don’t think a crowdfunded partnership could easily 1031x. I certainly could be wrong on this, and I would appreciate some feedback and correction if this is indeed true. In my own partnerships and fund holdings I was told it won’t happen.
I agree it’s not that easy, but it can be done and they’re offering that option more and more. Most of the investors in a syndicated property I recently bought were 1031 exchanging in from another property done by the same syndicator.
Good to know, it’s a great long term investment tool. Thx!
To perform a 1031 in a partnership is no more difficult than doing a 1031 as an individual property owner, from a compliance standpoint. The difficulty of doing a 1031 in a partnership structure is that sometimes not all partners want to participate in the 1031 and would rather cash out their investment. Only the owner of record can participate in a 1031 (i.e. the partnership entity). To get around this, the partnership can convert to tenancy-in-common (TIC) property ownership, while simultaneously distributing the property out of the partnership to the partners. This way, when the property is sold, it is deemed to be sold by the individual partners instead of the partnership entity (so some partners can cash out their investment and others can complete their 1031 exchange).
There is a situation that is likely to happen for me and I was hoping if anyone might be able to offer any ideas:
In the forum a month or so back I spoke of a potential to sell my medical practice building (it has been by far my best investment ever with around 25% annualized return (based on equity only (I additionally get a distribution quarterly). There is now positive movement to sell the building and I do feel it will happen by this year or early next.
My shares in the property will get me a 7+ figure payout (initial investment was less than 90k) so I am looking at large tax hit if it stands as is.
We just had a meeting with a ceo from another medical practice that sold (very positive experience) and he said that they negotiated a reinvestment option of 10% of the equity. He did say that those who took advantage of this were NOT able to take advantage of a 1031 exchange (I was wondering why this is not the case because it is about as like a property transfer as you can get).
If that is indeed not an option to do 1031 exchange is there a way that I can get my shares to do a 1031 exchange only (apart from other investors (ie. Does it have to be a all or none issue)? And would transferring from a medical use building to say a multi family commercial apt be a like exchange or does it specifically have to be medical use only)
It doesn’t have to be medical building for medical building. I don’t know what the reinvestment option for 10% of the equity would be. Is that some kind of exchange? At any rate, you should be able to do an exchange, but finding the new property in time is going to be all on you.
I think the way the meeting we had with the practice that sold said this about the reinvestment option they negotiated:
They sold the building to the buying group and then they were allowed to be able to re invest money in building for a total of 10% of the equity that was bought with actual cash (50% of deal was financed) so in essence 5% of the entire asset.
They said that they had lawyers and accountants look into it and said that this money going back into re-investment would not qualify as a 1031 exchange.
I agree the timing is the hardest part of getting money out and into something else that quickly. Will be challenging but if I can avoid 200+k of capital gains taxes it would make it worth it to find something
This is what is known as a Section 707 Disguised Sale. This is one of the most complicated areas of partnership taxation. You essentially contribute your entire partnership interest to a new entity (the purchaser entity). The purchaser then cashes out part of your investment (this is the disguised sale aspect of the transaction). You then retain the remaining portion of your investment that wasn’t cashed out. You get to defer the gain on the portion of the partnership interest that you retain, but you pay tax on the part that is cashed out.
Normally when cash is distributed to a partner in a partnership, it is not taxable, but in the case where new outside partner money comes into a partnership and another partner is cashed out within 2 years, the IRS deems this the sale of a partnership interest and not a normal distribution of cash, hence the term “disguised sale”. If you take this route, make sure you have qualified attorneys and CPAs with experience dealing with these transactions, as this area of partnership taxation is very complicated and not often seen by most practitioners.
I was wondering what the fees are for the intermediary for anybody that has every done this type of exchange? If the fees are high would there be diminishing return on smaller investments like single family residential? Kind of like segmented depreciation where you have to have a CPA or engineer provide a detailed appraisal at $5,000 to $10,000 per, it just isn’t economical. I am just wondering if this makes sense on smaller investments
There is some hassle and additional expense, but I think the expense is usually fairly minimal compared to the value of the tax deferral.
I’ve seen fees in the range $500-$1000.
But I’ve been reading some horror stories about some of these intermediaries. Apparently, there’s not much regulation.
I may be doing this soon. It would be great to have a list of trustworthy companies.
Can 1031 exchange be used to sell/buy primary residence, or it has to be an investment property owner doesnt live in?
Investment, but there advantages at times to moving in and out of investments in both directions.
A 1031 can never be used on a primary residence. You are able to permanently defer $250k of gain ($500k if married filing jointly) on the sale of a primary residence though.
Thanks for the informative piece. I agree that a 1031 is a great option if one wants to stay in real estate. When my medical office building finally (?ever) sells, I plan to use a Deferred Sales Trust. I’ll still defer taxes but will have more options for investment outside of real estate. Thanks, Harry
All right, I see your link is to a DST, but let’s hear more about it.
The asset on which you want to defer taxes is transferred to a trust. Can be any asset sold really – real estate sale, medical practice sale, sales of surgery center shares, etc. The assets are then invested – real estate, REIT, stocks, bonds, green energy, etc. The individual receives payments from the trust and will gradually pay taxes. Technically, an installment sale for accounting/tax attorney types. Fairly flexible. For example, I plan to take zero out for 2 years, then 2% for 2 years, then 4% for 2 years, etc. This particularly strategy probably won’t allow the indefinite tax deferral as would a 1031. (Full Disclosure: I have a potential financial interest in this technique tho haven’t made a dollar thus far. Still practicing FT and have multiple side gigs.). Thx Harry
Why do you need the trust? This is a revocable trust I assume. Does that somehow allow you to claim that it’s an installment sale even though the buyer got all their money up front?
You can do without a trust if you (the seller) is providing the financing. If it’s a cash deal or a bank/financial institution is involved, and the seller takes full payment — all taxes are due. The asset must be transferred to the trust PRIOR to the sale. The trust then sells the asset and takes control of the money. I believe the trust is irrevocable. The seller never takes control of the funds. I hope I answered your excellent questions clearly, Jim. Thanks, Harry
Blogging note: Love the superscript link. It keeps the readability easy but the access to extra info flowing.
One thing that some folks will want to keep in mind: Sec. 1031 and the new Sec. 199A deduction don’t play well together.
For real estate investors, for example, you may need basis in order to create a Sec. 199A deduction. (This would be especially likely if one’s employment income is high.) But Sec. 1031 minimizes basis.
Sec. 199A doesn’t mean Sec. 1031 doesn’t make sense… but you want to ‘run the numbers.’
Look into the requirements for becoming a 1031 intermediary. Not exactly FDIC. That’s worth a post by itself.