If you’re into real estate investing, then you’ve probably heard the term “1031 exchange” at some point or another. In this article, we will explore the world of a 1031 exchange in real estate investing and uncover the main benefits of a 1031 exchange for increasing your overall profits when investing.
Before jumping into the benefits of the 1031 exchange, it’s important to note that this article will not go in-depth about the rules of a 1031 exchange in real estate, but will only mention them briefly as I try to focus more on the benefits of the 1031 exchange and how to utilize them.
For a more in-depth article about the rules, you can read this 1031 exchange article.
What is a 1031 Exchange?
To put it simply, a 1031 exchange is a law that allows owners of real estate properties to exchange their property for another similar property in order to avoid paying capital gains taxes on the sale.
Named after section 1031 of the United States Internal Revenue Code (26 U.S.C § 1031), this law has been used by some of the most successful real estate investors over the past several years, and it proved to be especially useful for professional investors who like to take the gains from their investments and reinvest them into additional properties to grow their portfolio.
In a 1031 exchange, an owner who wants to sell their property (referred to as Relinquished Property) – instead of selling it and taking the cash – can exchange the property for another one that is “similar” (referred to as Replacement Property), and therefore will not have to pay taxes for any profits that the owner has made when selling the relinquished property due to appreciation.
The one part in this description that is often misunderstood is the part that says “similar property” or “like-kind property”.
In the context of a 1031 exchange, the similar property doesn’t refer to properties that have similar characteristics. Instead, it refers to properties that have similar uses.
To further understand what counts as a similar property, as well as a few other noteworthy rules that you need to know, let’s briefly talk about the rules of a 1031 exchange – once again, for a more in-depth article, read this article.
Rules of 1031 Exchange
The rules of a 1031 exchange are not simple, but they’re also really not that complicated.
Once you get the confusion of what like-kind property is out of the way, most of the rules of a 1031 exchange will make sense and seem very logical.
So, before talking about the benefits of the 1031 exchange, let’s take a brief look at the rules:
What exactly is a like-kind property?
A like-kind property in a 1031 exchange is a replacement property that has the same use as the relinquished property.
This means that commercial and personal properties fall into two different categories.
If you’re using the property as a source of income, an investment, or as a business, then it counts as a commercial property.
If you’re using the property as a primary residence or a vacation home, however, then it counts as personal property.
Price of the Replacement Property
Another important rule that you need to keep in mind in order to reap the benefits of the 1031 exchange is that the price of the replacement property that you’re purchasing must be equal to or greater than the sales price of the relinquished property.
This includes the additional costs which incur, such as the acquisition costs for the relinquished property and the sales expenses for the replacement property.
Owned by the Same Taxpayer
Also, important to note that the taxpayer who owns the relinquished property must be the same person or entity that will own the replacement property.
In this case, the taxpayer can be a real estate investor, an LLC, a C Corporation, or a partnership.
Another important thing to note is that; in a 1031 exchange, you cannot sell your relinquished property to, or buy your replacement property from, or swap properties with, a person related to you without having certain conditions imposed.
A related party, in this case, is a spouse, sibling, child, grandchild, parent, or grandparent.
Is There a Time Window?
There are two noteworthy time windows that I should mention when it comes to the rules of the 1031 exchange:
- 45-Day Period: After you sell your relinquished property, on your exchange date, you have 45 days in which to identify in writing to your qualified intermediary a list of the possible properties that you will purchase as replacement property.
- 180-Day Rule: You must close on the purchase of your replacement property within 180 days after the exchange date.
I want to point out that there are more details about the 45-day period rule that are related to exchanging one property for multiple properties – you can find them in the in-depth article.
Benefits of 1031 Exchange
Now that we’ve covered all the basics, let’s talk about the benefits of 1031 exchange in real estate investing, as well as some investment strategies that will benefit the most out of this rule.
The main benefits of the 1031 exchange revolve around the aspect of paying less taxes – because, let’s face it, who doesn’t want to pay less tax, right?
Capital gains taxes, especially in the case of selling a real estate property, can be very significant.
In case you don’t know what capital gains taxes are – they are the taxes that you pay whenever you make a profit on a sale.
For example, if you’ve bought a house for $100,000, which has appreciated in value over the years, and you want to sell it now for $180,000, then you will have to pay capital gains taxes on the $80,000 profit that you’ve made.
However, in this case, you can instead use a 1031 exchange to sell the house for $180,000 and buy another like-kind house using the $180,000, and you won’t have to pay any capital gains tax on that exchange!
At this point, you might be thinking: but what if I wanted the cash? I don’t need another property!
In this case, this section is not for you, as you’re not thinking about creative ways to use this rule to make even more money in the long term.
So, with that being said, let’s talk about the best investment strategies to use with a 1031 exchange to reap the benefits of the 1031 exchange:
Investment Strategies
There are many ways in which a 1031 exchange can be utilized to make profitable investments in real estate – mostly by snowballing your profits from investing and allowing you to own several new investment properties without having to pay capital gains taxes along the way.
However, if you’re not a career investor with tens of properties under your name, then you’ll want to know about a couple of strategies that any investor can use with ease to make a profit using the 1031 exchange:
Super Landlord
Do you fancy yourself as a great landlord? Do you think you’re capable of taking a negative cash flow property and turning it into a positive cash flow property using your amazing property management skills?
This strategy is for you!
It’s a simple rental strategy that revolves around your ownership of a rental property that is performing very well. This leads to the property’s market value appreciating, allowing you to sell it at a higher price.
Using the 1031 exchange, you can then look for like-kind properties in the same market that are performing below average and valued accordingly.
You buy those properties (you can buy multiple depending on the price) and you improve their performance, which earns you a passive income while you own them before you sell them again at a higher price using another 1031 exchange…and so on, and so forth!
The trick in this strategy is that you need to make sure that the replacement properties that you’re going after are low performers due to bad management or any other factor that you can control and improve (like if they need maintenance or renovation), and not due to an unchangeable reason such as a bad location.
Read: What Is a Subordination Clause in Real Estate? Learn How They Work?
Appreciation
A 1031 exchange also pairs very well with a buy-and-hold strategy that focuses on earning profit from appreciation instead of generating a positive cash flow.
In this case, you’re banking on the property’s appreciation and hoping that in a certain number of years, you will be able to sell the property for a profit.
For example, you might be selling a property that has appreciated in value over the past 10 years, and you intend to sell the new property you’re buying after 10 years as well.
What you do, in this case, is that you look for other like-kind properties that have a high potential for appreciation in the short to the long-term time window.
Of course, you won’t really be selling for cash! Instead, you will be using the benefits of the 1031 exchange to avoid paying taxes on the appreciated value after each sale, owning more and more properties over a long period of time.
To find properties that have a high potential for appreciation, it’s important to have good sources of knowledge and be well knowledgeable on the market.
Look for signs that a property will appreciate in value in the future, such as new city projects in the area which will attract a high number of residents, like a new train station for example, or a new office building for a successful corporation, or even a new school district which is being built nearby!
Vacation Property
You’re not a real estate investor, but you’re still looking for ways to benefit from the 1031 exchange? No problem!
The beautiful thing about the 1031 exchange benefits is that they’re not only for investors, but any property owner can take advantage of them.
If you’re a residential homeowner and you want to 1031 exchange a single family home, for example, you can do so as long as the replacement property is also personal property.
So, one strategy, which does count as an investment considering it helps you save money in the process, is a strategy that involves vacation properties in particular.
This strategy is all about leisure and giving you options when it comes to your vacation property where you spend your time away with family and friends.
For example, if you own a vacation property in a great location, but you kind of got bored of it after a few years, you can use a 1031 exchange to get another vacation property in a new location without having to pay taxes on the deferred gain on sale of the property.
Read: Google Vacation Rentals: The Real Estate Investor’s Guide
Use the Property Marketplace
If you own a property and you want to 1031 exchange into an existing property, then there’s no better place to both sell your property and find a replacement property than the Mashvisor Property Marketplace!
The property marketplace is a great place for you to start, whether you’re an investor or just a homeowner who wants to 1031 exchange into an existing property. Using the property marketplace, you can easily list your property for sale while also browsing through lists of like-kind properties which come complete with all of their details and owner info for you to contact with ease.
What’s more, is that the property marketplace is connected with our analytics tools and calculators.
This means that you will also have access to see the properties for sale AND their projected returns and historical rental performance, allowing you to make your decisions with ease and accuracy!
Conclusion
When it comes to the 1031 exchange benefits, they are as numerous as the creative strategies that you can think of.
The benefits of the 1031 exchange all revolve around the aspect of selling a property for a profit without having to pay taxes on the deferred gain on the sale of the property.
Using that logic, you can easily think of ideas and strategies to build around it based on your particular case and use.
And don’t forget to check out Mashvisor and use the best tools available for real estate investors to make your investment journey that much easier!