It can be a smart strategy for deferring taxes on real estate investments, but the rules are complicated.
Selling real estate can turn a large profit, but it also comes with a large tax bill. That's where a 1031 exchange comes in handy: by offering you a deferred tax break. But 1031 exchanges are complicated and have strict requirements, which means they're not for everyone. Also known as a like-kind exchange, a 1031 exchange allows real estate investors to put off paying capital gains taxes on the sale of a property under one condition: You must buy a similar property within a specified time period, essentially "trading" one investment property for another.
"In a nutshell, you're swapping one property for another, and the new property takes on the basis of the previous property," said Marianela Collado, CEO of Tobias Financial Advisors.
Because a 1031 exchange is a complex tax strategy, it's usually employed by sophisticated investors who plan to keep buying and selling properties that will appreciate in value over time. It's not something you should try to tackle on your own. Keep in mind, a 1031 exchange does not eliminate your tax bill; you're just kicking the can down the line. So while you may be able to defer your capital gains taxes for years, you'll have to pay Uncle Sam once your replacement property is sold.
Typically, when you sell a business property, you're taxed on your capital gains (the long-term appreciation of the property) and over time you also have to pay a depreciation recapture tax on the property (which is income tax you'd ordinarily have to pay on the gain realized from the sale). For taxable transactions over $250,000 of economic value, you usually have to pay a net investment income tax of 3.8%.
But if you want to sell an investment property and use the money from that sale to buy another property, you could use a 1031 exchange to avoid paying these taxes at the time of the transaction, effectively deferring your tax bill.
Although the long-term goal of an investment exchange like this is deferring capital gains taxes, real estate investors shouldn't expect any money in the short term. A straightforward 1031 won't produce any income or give your bank account an injection of cash.
"You must reinvest all the proceeds to defer paying tax on all the gain," said Collado. "In other words, you can't just reinvest the gain." For example, if you sell a property for $100,000 and the gain is $75,000, you have to reinvest the entire $100,000 worth of proceeds to avoid paying tax on the $75,000.
In most cases, you can only employ a 1031 exchange on business or investment property. Let's say you own a beach house that you regularly rent out and earn consistent income from. This investment property would qualify for a 1031 exchange if you decide to sell it and buy a new, similar investment property.
However, if you own a residential property that you use as a vacation home and occasionally list on Airbnb, you can't use a 1031 to sell this property and buy a new vacation home with deferred taxes. This is because the property won't be classified as an investment or business property.
While a like-kind exchange must trade one investment property for another, it doesn't have to be for identical types of properties; it works as long as the properties are comparable. So you can sell a vacation home you regularly rent and reinvest the proceeds to purchase a parking lot... as long as that parking lot is for business purposes.
One of the most common mistakes people make when attempting a 1031 exchange is missing the deadline to find a new property. You only have a small window of 45 days to identify your next investment, and you must close on that property within 180 days (which includes the 45 days). Otherwise, you won't qualify for this exchange.
"Unsophisticated buyers and sellers have a hard time meeting the timing requirements," said Matt Chancey, a tax shelter & private equity consultant with Coastal Investment Advisors. Plus, it's easier for buyers and sellers to take advantage of the time-crunch someone in a 1031 exchange is experiencing, knowing they only have 45 days to find a new property and 180 days total to close. That means you could end up underselling your first property, overpaying for the second or both.
When you exchange real estate, you can't just take the money you earn from selling the first property and deposit it into your bank account. It has to be held by a specialized custodian known as a Qualified Intermediary, an independent agent who facilitates a part of the exchange that real estate investors are legally not allowed to handle on their own.
"The QI is basically just a custodian that will hold your funds when the real estate transaction closes. If you co-mingle those funds or take constructive receipt, you're no longer eligible for a 1031 exchange," said Chancey.
If you take receipt of the funds before the exchange is complete, you could end up triggering a massive tax bill for yourself, eliminating the tax-deferral benefit.
You can find a QI through an organization like the Federation of Exchange Accommodators to help you find someone in your specific state -- something that can be critical, as state and local taxes can vary widely.
Even for experienced investors, financial advisers recommend partnering with necessary qualified professionals -- like a CPA, real estate attorney or an exchange agency that specializes in 1031 exchanges -- to prevent any hiccups.
"Don't trip over pennies on the way to dollars," said Chancey. "If you need a good real estate or tax attorney, get one." Plus, one of the relevant financial professionals you work with can often act as your QI.
A 1031 exchange is a valuable tool for deferring capital gains taxes on investment properties, but it is a strategy that requires intimate knowledge of the myriad kinds of taxes associated with real estate transactions. You should always hire professionals to support you throughout the process.
And although a 1031 exchange is an efficient way to delay taxes, once you're ready to sell your final investment property and won't be purchasing a new one, your tax bill will finally be due.