1031 Exchange

What is a 1031 Exchange and How Can it Benefit You?

Being a good real estate investor takes more than just finding great deals and flipping them for a profit. In order to succeed at the highest level, an investor must be aware of the tax code and be able to take advantage of all of the tax breaks that are offered to real estate investors. Investing in real estate is often more complex than investing in other asset classes because the tax code does offer more breaks and opportunities for real estate investments that are not offered elsewhere. One of the most important and often used tools available to investors is called the 1031 exchange, and every successful real estate investor must be aware of what it is and how to use it.

What Tax Codes Benefit Real Estate Investors?

A 1031 exchange, named for the section in the tax code where it can
be found, is a way for investors to sell one property and use the proceeds
to purchase another property while deferring the capital gains until a later
date.
Generally speaking, when an investment property is sold, any
increase above the original purchase price of the property must be reported
to the IRS as a taxable capital gain. When a second property is purchased
with those capital gains, the taxes can be deferred until the second
property is sold later.
There is no limit to how often those capital gains can be rolled over
into a new property. Thus, it is possible for an investor to defer the taxes
indefinitely.

Should You Sell Your Underperforming Property to Invest in a Better Market?

On the national level, we know that properties tend to appreciate at different rates in different markets and geographic locations. In some areas of the country, real estate is not as good of an asset class as it once was.
Take California, for example. Changes in zoning, environmental, and rent control laws have made being a landlord nowhere near as lucrative as it once was. Many investors are sitting on properties with massive increases in value but can no longer be rented out at market rates due to rent control laws.
If an investor were to sell their property and get out of the business, they would generally be hit with a huge capital gains tax bill. But if they stay in business and invest out of state, the 1031 exchange can be used to avoid the tax.
Some areas of the country right now are spectacular places to invest.
Certain midwestern markets in states such as Wisconsin, Indiana, and Iowa have generally affordable real estate for sale that can be rented out for a nice monthly cash flow. In addition, they generally have landlord friendly laws that eliminate many of the headaches that California landlords deal with on a daily basis.
If you are an investor in California or a similar state, a 1031 exchange to a property in a different state may be a wise move.

Guidelines for a 1031 Exchange

If you are going to take advantage of a 1031 exchange, it can save thousands or more in taxes, but some rules must be followed, and everything must be accurately reported to the IRS. Knowing exactly how it
works is then crucial to avoid any issues later.
Three general rules must be followed when using the 1031 exchange.
The first rule is called the like-kind rule. Basically, this stipulates that both properties in the exchange must be similar properties. For example, if an
investor is selling an apartment building and wishes to use the proceeds to purchase another property if the 1031 exchange is being used, then the investor must purchase another property similar to the original apartment building. If they were to purchase a commercial warehouse, the 1031 exchange would likely be denied by the IRS.
The second rule is called the 45-day rule. This stipulates that within 45 days of the closing of the sale on the original property, a new second property must be identified. More than one property may be identified, so an investor can sell a property and then, within 45 days, identify several other properties that may be purchased with the funds. This gives the investor some leeway in choosing a property before actually committing to the purchase.
The third rule is called the 180-day rule, and it runs concurrently with the 45-day rule. This rule states that the closing for the second purchase must occur within six months of the closing of the original sale. If more than six months pass, the 1031 cannot be used. There is one other rule that must be followed as well. In order to use the 1031 exchange, the investor must never actually take possession of the proceeds from the sale of the first property. At closing, the funds must go directly to a third party escrow account. If the seller does take possession of the funds and deposits them into their own account, even temporarily, the 1031 can no longer be used.
When using the 1031 exchange, it is recommended that the services of an experienced real estate attorney be used, especially for the first few times. This will ensure all the rules are followed and all the paperwork is appropriately filled out.

Why it Pays to Invest in Real Estate

Using the 1031 exchange strategically can save enormous amounts of money on taxes and help build a real estate empire. When properties go up in value, which they almost always do, the capital gains and corresponding taxes can be quite substantial. Deferring the taxes until a later date allows for much more capital to be deployed into new investments, allowing the entire portfolio to grow using the snowball effect. Since the 1031 exchange can be used an unlimited number of times, an investor can keep rolling over the properties indefinitely and essentially never have to pay any capital gains taxes at all. When a portfolio eventually gets passed on to heirs, the tax code allows for the step up in basis to the property’s value at the original investor’s date of death. Thus, the capital gains tax never has to be paid