It’s true – having rental properties is a great way to make money. As long as you get good tenants settled into a long-term lease, you can begin to put that money back into purchasing more real estate. But you really don’t have to wait for years until you’ve built your account back up! There is a way to build your real estate investment portfolio and increase your tax flow without saving money first. The answer is a 1031 exchange.
What Is a 1031 Exchange?
A 1031 exchange is a piece of tax code that gives you a way of taking an investment property, selling it, and using all of the profits to put down on more properties. While you could do this without a 1031 exchange, using the exchange saves you from paying tax on the money you make from the sale at that time by deferring it.
Why Is This Important?
When you own a rental property, you are able to deduct the depreciation of the home on your taxes. It’s one of the great perks of owning a rental property! As you go to sell that property, however, you have to pay most (if not all) of that depreciation back. Not only that, you also pay capital gains tax on the amount that you make in your home. If you were planning on using that money for a new investment property, you now have a lot less to work with.
Let’s say that instead of selling the home outright, you sell the house and use the 1031 exchange. Now the money you make from the sale is exempt from all taxes – not just capital gains and depreciation recapture. This allows you to take all that money and put it right back into up to three investment properties.
Rules of 1031 Exchanges
As with all things that seem too good to be true, there are rules. While some of these rules seem pretty straightforward, there is some back-bending that may need to be done to accommodate them.
Reason for Owning Property
You can only use a 1031 exchange on investment properties. While the home could be used for your primary residence as well as investment purposes, you cannot use a 1031 exchange to switch your non-investment property out for an investment property.
Length of Ownership
You need to have owned the property for at least two years before you are able to use a 1031 exchange. If you invest mainly in flips, 1031 exchanges are not for you. You can’t use a 1031 exchange to purchase a rundown property, fix it up, sell it in 60 days, and use the equity to acquire a more massive fixer-upper. It won’t work.
Name on the Title
You cannot use a 1031 exchange if the property being sold is in one name and the property you are going to buy is going to have you as well as others on the title. The name on the sold title is the only name that can be on the title of the property being exchanged. It sounds a bit confusing, so here’s an example:
John Smith buys a single-family investment house for $100,000 and sells it for $150,0000. He uses a 1031 exchange and wants to put the $50,000 down on two investment properties he is planning on co-owning with his new investment partners. Because only John Smith’s name is on the first title, his is the only name that can be on the title of the properties bought in the exchange.
Tight Closing
When completing a 1031 exchange, you must find the properties that you intend to complete the exchange on within 45 days of closing. From there, you only have 180 days to close on the new properties. Because of the small closing window, it’s a good idea to locate the properties you want to exchange before selling your first investment property.
Same (or Greater) Budget
If you buy a $100,000 house and make $20,000 worth of equity in it, you must find a property or a group of properties that equal $120,000 or more. An example of this is if you are selling a duplex for $300,000 that you have $100,000 equity in. You cannot go out and purchase a property for $100,000 cash through a 1031 exchange. You can buy that property as well as one or two more for more than $300,000 but no more than $600,000.
How Do You Get Started Using a 1031 Exchange for Rental Properties?
The first thing to do when you use a 1031 exchange on a property is to begin to look for the properties you want to exchange it with. Make sure you fall in love with the ROI, not the properties themselves! You want to have a general idea of the properties you are going to purchase before you list your own property. While listing the home for sale, it’s essential to work with a real estate agent who is familiar with 1031 exchanges to help you through this process.
The second thing you’ll need to do is to get under contract with the buyer. Make sure you notify the buyer that you are using a 1031 exchange, as there may need to be some provisions in the agreement for the exchange.
After accepting an offer and closing on the sale of your house, you’ll need to identify an intermediary. An intermediary is someone who will hold your money in an escrow account until closing. Because you are not allowed to touch the money from the sale of your property to the purchase of the new properties, you need to have someone hold the money for you. Some intermediaries work specifically with 1031 exchanges, but they do require a fee to keep the money for you. The key is finding an intermediary you trust.
Next, you need the HUD’s approval. They’ll check to make sure all requirements have been met to this point, and give the OK for you to proceed.
At this stage, you’ll need to get your properties chosen. You have 45 days to stake a claim, and 180 days to close. Be prepared to move fast and make preparations, so nothing delays the process. Be especially aware of the 45th and 180th days. If your 180th day falls on a holiday or a weekend, you’ll need to close before then. Knowing this in advance will help you sail straight to close – without taxes in tow.
Once you complete your 1031 exchange, many wonder if they’re allowed to do it again. The answer is a resounding yes! You could essentially keep deferring the taxes of your investment properties while increasing your investment portfolio. If you need money from one of your properties, instead of selling it and paying the taxes, you could take out a line of credit from the equity on one of your properties.
They may seem a bit complicated at first, but 1031 exchanges are the rental property owner’s best friend, and they can be yours too! Talk to your CPA and a real estate agent about your options and get building your portfolio today!
This article has been contributed by our friends at Clever Real Estate.