Have you ever heard of a 1031 Exchange? This is a little-known opportunity that could potentially save you thousands of dollars. A 1031 Exchange can be utilized when you sell an investment property and exchange it for another investment property of equal or higher value. The primary use of a 1031 Exchange is to save the money you would have paid in capital gains tax from the sale of the first property and roll that equity over into a second property.
The 1031 Exchange is a tax deferral strategy to save on capital gains taxes when you sell an investment property at a gain. Example:
- 1990: You purchased or inherited an apartment building for $100,000. That’s your original basis in the property.
- Over the years, you depreciated the property basis down to $0, a nice strategy that allowed you to reduce your annual tax bill.
- 2020: You sold this apartment building for $1 million. “Knock, knock, knock…” That’s the IRS at the door. You may owe approximately $300,000 in federal and state taxes.
In the above example, there is a way to defer this $300,000 tax and have your heirs potentially avoid it altogether. If you simply sold the property and took possession of the funds at closing, it is already too late. The capital gains and Medicare tax will be due. Yet if you enter a 1031 exchange, and do it correctly, using a Qualified Intermediary* to take possession of the closing funds, you can instead reinvest the full $1 million in another investment property and defer 100% of the taxes until you sell the new property. Here’s the great part though: you can keep on doing 1031 exchanges and deferring the taxes. If you die before the taxes have been paid, they vanish. Your beneficiaries will not be required to pay that tax burden as they likely will receive a full step-up in basis to the current market value.
This exchange is most popular with real estate investors. It is easy to keep doing 1031 exchanges and gradually increasing the size of the property (i.e., getting larger and larger apartment buildings). Overall, it is a tool that anyone can utilize to defer taxes and build wealth in the long term.
A Few Rules for 1031 Exchanges:
- The first rule is that the property you are exchanging for is required to be a like-kind property. You can trade any real property for another real property. An example is you could trade an apartment building for raw land or a farm for a strip mall. The rules are lenient here, however you cannot trade property for stocks or anything else that is not real estate.
- The second rule is the 45-Day rule. This rule means that once you sell your property, you have 45 days to give the money from that sale to an intermediary. If you do not, it could ruin the exchange. You also only have 45 days from the sale of your property to identify another property you plan on acquiring with the money from your sale. If you do not find another property in those 45 days, the exchange falls through.
- The last rule is the 180-day rule. This rule means that after you sell your property, you have 180 days from then to buy, and close on another property. If your sale and purchase do not fall into these guidelines the 1031 exchange is eliminated and you would be required to pay the taxes.
Vacation Homes
The 1031 exchange has benefits, but it is not for everyone. The unfortunate aspect is that you cannot use the exchange for personal residences. It is required to be used on investment properties. There is a gray area that it could be used for vacation homes or second residences. The way this would work is you would have to rent out the property for more than 14 days every year, for fair market value. By doing this you can stay at this property for up to 14 days per year. If you decide to rent it out longer you can stay at the property for 10% of the time you rent it. An example would be if you rent the property out for 300 days per year, this means you would be able to stay at this property for a total of 30 days per year. So, there is a way to do this for vacation homes, you would just have to rent it out for the required amount of time.
With real estate valuations climbing so much these last twenty years, just consider the below example to see the value realized for a client, a $1.2m difference!
Perennial Edge is well-versed in 1031 transactions for those wishing to get out of the real estate sector. Feel free to contact us to have an initial conversation.
* We work with some Qualified Intermediaries.
