If you are a real estate investor in 2019, the odds are very, very good that you have heard of 1031 exchanges. However, if you are like most real estate investors in 2019, you do not really know exactly what a 1031 exchange is or what it can do for you.
1031 exchanges are a hot topic, particularly for investors who own properties that will generate a great deal of profit when they are sold. However, these handy transactions can be a huge headache for the investor who knows “just enough to be dangerous.”
Fortunately, by the time you are done reading this article, you will be well equipped to leverage 1031 exchanges in your real estate portfolio – with the appropriate professional assistance of course!
What Exactly Is a 1031 Exchange?
Before we can dig into the details of 1031 exchanges, let’s summarize these beautiful little tax-code creations in a single sentence:
A 1031 exchange is a transaction in which you swap one investment for another in such a way as to push the tax consequences far into the future (or sometimes even eliminate them).
Now, let’s look at an example:
Say you sell off one of your investment properties for a profit of $200,000. Under normal circumstances, that profit will be subject to some taxes at the point of sale. In fact, you could end up owing about a third of that $200,000 in capital gains taxes! Once you have paid your “dues” to Uncle Sam, you still will likely have about $140,000, but wouldn’t it be nicer to have the full $200,000 to use for future investments instead?
That is where 1031 exchanges come in. They help you keep your investment returns where they belong, in your available investment capital, so that you can fully leverage your full profits after transacting a profitable deal.
However, there are a few things that you really need to know about 1031 exchanges before you start strategizing about how they might apply to your specific real estate investment portfolio. Five things, to be exact. Knowing these valuable points in advance will help you, as a real estate investor, effectively leverage this highly valuable strategy in your investment portfolio.
#1: 1031 Tax-Deferred Exchanges Are Ideally Suited for Real Estate
You can use a 1031 exchange for a wide variety of investments, but they are primarily used for real estate. This is due in large part to these two factors:
1. Real estate transactions tend to yield relatively large profits where a lot of money is “lost” to capital gains taxes without the right strategies in place.
2. Real estate investments are uniquely suited to meet several “unusual” guidelines governing 1031 exchange transactions, as you will see in #2.
#2: The “Exchange” Must Be “Like-for-Like”
The description “like-for-like” is perfect, because it means that when you swap one investment for another, the federal government must officially consider those investments what the IRS refers to as “like kind.” This means, for example, that you cannot swap precious metals for a dairy farm.
Fortunately for real estate investors, with very few exceptions, the federal government considers most types of real estate to be equivalent. This means, for example, that if you sell off a vacant lot in a hot area of California for $550,000, you could then invest in three vacation rentals in Florida while still meeting the like-kind requirement. This enables real estate investors to optimize their profits by shifting their focus to different markets or even different investment strategies within the real estate sector while still utilizing 1031 exchanges to keep their capital intact.
#3: 1031 Exchanges Must Be Speedy
If you like to take your time and do a lot of thinking about your investment decisions, then you deserve praise for being a responsible and probably very successful real estate investor. However, you also require a warning: 1031 exchanges do not allow a lot of time for reflection. In fact, once you sell the first investment, you have only 45 days to identify and designate a replacement investment for the “swap” angle of the 1031. Then, you have only 180 days to get your profits from the sale of the first investment reinvested into the second investment.
Most real estate investors deal with the time issue by planning their 1031 exchange transactions before they have sold their initial investment. This gives them time to plan and do plenty of due diligence before they enter the race to reinvest.
#4: Your 1031 Exchange Must Be “Cash-Free”
Going back to our example where you sold a property for $200,000 in profits, let’s assume that you identify a great $180,000 investment that you want to use those profits to purchase. Once you have completed the 1031 transaction, what happens to that other $20,000? Is it just yours to pocket, tax-free?
Unfortunately, no. That $20,000 will be taxed as capital gains, but at least you are being taxed on about 10% of your gains instead of all of them!
#5: The 1031 Exchange Cycle Is Nearly Eternal
You’ve heard the phrase, “Nothing lasts forever.” Fortunately for your investment capital, a 1031 exchange very nearly will. There are very few restrictions on the number of times you can do a 1031 exchange after your initial investment. As long as you follow the rules, you might take that $200,000 profit we described in the example, turn it into $400,000 in profit, then do another 1031 exchange protecting the entire $400,000 and eventually create $800,000, then continue indefinitely.
However, while there are few limits on the volume of 1031 exchanges you can do, there are limits on how frequently you can conduct these transactions. Some tax professionals say you can only exchange assets every two years, but the real facts of the matter hinge on your unique circumstances, since investments that are eligible for this transaction must, among other things, be considered to have been held “for productive use in a trade or business for investment.” If you meet the terms sooner, then you might be able to do 1031 exchanges more often. If you arguably do not meet those terms after two years, then you might need to hold off on the transaction. Your tax and legal professional advisors should be able to help you determine if a given asset is eligible for a 1031 exchange at a given time.
Wondering why vacation rental properties, both short- and long-term investments, are such a popular type of asset for use in 1031 exchange strategy? Learn more about 1031 exchanges and other tax-advantaged investment strategies at SelfDirected.org.
This article has been contributed by SDISociety.com.