Phil WestBy Phil West, WCI Contributor

There are several tax advantages to investing in real estate. That doesn’t mean, however, that every real estate investment is one you want to hold on to forever. If there’s one you’d like to divest yourself of, you can certainly sell it, though you do have to factor in the capital gains tax that comes with that. But what if you had a way to defer that tax hit, and you could swap a real estate investment you no longer wanted with one that’s caught your eye? That’s where a 1031 exchange can come in. 

Here's more information on what a 1031 exchange is and how you can use it as an investment strategy.

 

What Is a 1031 Exchange?

Let’s start with the basics: A 1031 exchange is a process that allows you to exchange your investment property equity into another property while deferring the capital gains (and depreciation recapture) taxes due. It’s possible to do multiple exchanges over time, as long as, in each case, there’s an exchange of one property for another. Its name comes from the Internal Revenue Code that the IRS maintains—namely, Section 1031, covering what’s dubbed the “like-kind exchange.” 

As the IRS explains, “IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.” 

The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities, and property that are not like-kind. If you receive cash, relief from debt, or property that is not like-kind, however, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.

More information here:

Real Estate Investing 101

 

What Are the Basic Rules Around It?

As we detail in our No Hype Real Estate course, you have to identify the property within 45 days and complete the transaction within 180 days. It also has to meet the IRS’s like-kind definition, though that’s a fairly broad category. 

As WCI Founder Dr. Jim Dahle says in the course, “You could swap vacant land for a house, an apartment building, a strip mall, a warehouse, a hotel, or ranch. But you can't swap an investment property for a house to live in and vice versa.” You also have to make sure the properties being exchanged are both in the US.

A Forbes article on the subject adds: “There are ways you can use a 1031 for swapping vacation homes, but this loophole is much narrower than it used to be.” It also notes, that because it can be difficult to find a trading partner who has exactly what you want . . . 

“The vast majority of exchanges are delayed, three party, or ‘Starker’ exchanges (named for the first tax case that allowed them). In a delayed exchange, you need a middleman who holds the cash after you ‘sell’ your property and uses it to ‘buy' the replacement property for you. This three-party exchange is treated as a swap.” 

1031 exchange

Also, it doesn’t precisely have to be a one-for-one exchange. According to Forbes:

“The IRS says you can designate three properties as the designated replacement property so long as you eventually close on one of them. Alternatively, you can designate more properties if you come within certain valuation tests. For example, you can designate an unlimited number of potential replacement properties as long as the fair market value of the replacement properties does not exceed 200% of the aggregate fair market value of all the exchanged properties.” 

Cash left over from the transaction, however, may be taxed.

 

How Did the 1031 Exchange Get Started?

According to Realized, the 1031 change was created with the Revenue Act of 1921, and it was supposed to help investors by allowing them to defer taxes on these real estate investments. The idea was that investors would continue to reinvest their money into real estate. Various legislative acts throughout the 20th Century refined the process we now use today to conduct 1031 exchanges.

More information here:

How to Start Investing in Real Estate

 

How Can I Use a 1031 Exchange in an Investment Strategy?

The 1031 exchange is part of a buy-depreciate-exchange-depreciate-exchange pattern that can theoretically end with the death of the property owner. When that happens, the step up in basis at death rule kicks in, and the property goes to your heirs. 

In that scenario, if done correctly, nobody ever pays depreciation recapture tax or capital gains tax in this scenario. You won’t pay it in your lifetime, and your heirs won’t pay it either. But the key is making sure you’re following the rules. Aligning with a real estate lawyer or a good commercial real estate agent will help you dot and cross all the Is and Ts needed for a successful 1031 exchange—and, perhaps, doing what will be the first in a whole series of exchanges. 

 

Don't forget to sign up for the free White Coat Investor Real Estate Newsletter that will alert you to opportunities to invest in private real estate syndications and funds while giving you important tips for how to invest in this asset class.

 

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