Real Estate Investing 101: The IRC Section 1031 Exchange
With a booming real estate market for both sales and rentals, many investors seeking to diversify an income stream and find a tax-efficient asset are looking at direct investment into an asset class that is historically less correlated to the stock market. Owning, managing and maintaining an investment property has a host of tax benefits, but there’s also one unique treatment investors receive when it comes time to sell.
IRC Section 1031, commonly called a “like-kind” or “1031” exchange, 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. These gains are tax-deferred, but not tax-free – but you only pay the tax on the last property that is sold, not “exchanged.”
Building A Dynamic, Diversified Portfolio
Creating a real estate portfolio with growth potential that meets investors’ needs can often involve swapping out of assets – just like other forms of investing. The investor may want to leverage into more valuable real estate, shift to a different type of property usage to attempt to increase cash flow, create more geographical diversification, streamline management or even consolidate holdings. The 1031 exchange – which applies only to investment property – simplifies these changes by allowing the entire proceeds of the sale to be used towards the new property.
The Rules of the Exchange
The IRS defines like-kind property as properties that are of the same nature or character, even if they differ in grade or quality. Surprisingly, they’re fairly open on what qualifies as “like-kind.” As long as the real estate is being held for investment use, it’s possible to swap a piece of land for an industrial complex or an office building for an apartment complex. There are subtle nuances in the cost basis for each type of property, but the general idea is that you can exchange hard, tangible real estate for one of equal or greater value. If the new property has a lesser value than the one being sold, the difference in what you sold your original property at and what you exchange it for may be subject to capital gains.
When looking to participate in a 1031 exchange, there are a few things to keep in mind. The transaction is similar to how someone would normally sell a home but with an additional person involved, also known as a qualified intermediary, or QI. An intermediary takes the place of the seller and holds the money the seller would typically receive from the buyer. This is because the transaction is an exchange rather than a sale so to keep it 1031 eligible, the seller is not allowed to touch the proceeds from the sale.
The IRS has also laid out a few timeframes that must be followed for a transaction to meet the Section 1031 requirements. The first one that must be followed is the 45-day rule. Within the 45-day window of sale, the seller must either close a new deal or identify up to three replacement properties and specify it in writing. This form gets sent to the IRS to inform them you’ve found a viable property(ies).
Next, the seller has 180 days from the time the original investment property was sold to close on the new like-kind property. Going back to the intermediary, since they have the funds from the previous sale, they then acquire the replacement property and are able to transfer the new property to the original seller. The 1031 exchange is then complete and if all requirements were met, capital gains taxes would be deferred.
All properties must be in the U.S. to qualify. Additionally, primary residences, fix & flip projects, and time share typically do not fall under the qualification for 1031 exchanges. The real estate has to be for investment purposes.
Dying With a Portfolio of Real Estate
Real estate is an amazing estate planning tool for a few reasons. For starters, the stepped up basis allows for a beneficiary to inherit real estate that is valued at the predecessor’s date of death rather than at what they bought it for. In other words, the gain from the property gets zeroed out when you inherit the asset. The following scenarios are hypothetical illustrations of mathematical principals only and not a promise of performance.
Example: Sell before dying
Let’s say for instance you had a single family investment property in Carlsbad that Mom owned that was passed to you as a part of your inheritance. Now, imagine she and Dad bought that piece of real estate 25 years ago for $150,000. Now adays single family homes in North County San Diego and in many parts of Hawaii go for as much as $1,000,000 or more. If they sold their investment property prior to them passing away, they’d incur a capital gain of $850,000 ($1,000,000 - $150,000) – meaning they’d pay roughly $170,000 in taxes. *There may also be other state taxes that will have to be paid.
Example: Die before selling
If they passed away before you sold the property, then you would receive the asset valued at $1,000,000, not $150,000. The basis on the real estate gets stepped up, which means you could effectively sell that investment property with potentially very minimal tax consequences. Of course, you’d want to talk with your tax professional about your specific situation.
Example: Using the 1031 exchange
If your parents sold the property before they passed away, they could utilize the 1031 exchange rules to defer the expected long term capital gains of $170,000 (or more) by finding another property to move the funds to. They’d need to find and identify a replacement property within 45 days of them closing escrow on the sale of their investment property, purchase that new real estate, and close on that new property within 180 days. It’s extremely difficult to do that all in a red hot real estate market where sellers seem to be getting offers up to 25% above asking.
However, we are seeing a lot of real estate investors, particularly in Southern California who are using these rules to their advantage. They’re finding properties in other states that have more favorable economics and where the investment property laws favor the landlord.
Conclusion
A 1031 exchange can be an effective strategy to not only defer capital gains, but to help diversify a portfolio with tax-efficient real estate transactions. However, the IRS has laid out rules that must be carefully followed. There are many moving parts and deadlines that must be made to ensure a transaction qualifies for the benefits of a 1031 exchange and working with an experienced advisor can help determine the necessary moves to make (and keep) the most money in your pocket.
It's also important to note that the Biden administration has introduced legislation which would potentially alter or even eliminate this exemption. While the outcome of that legislation has yet to be determined, the information in this article is based upon the IRC as it currently written.
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