Maybe. Or maybe not, if you use tax loopholes like a 1031 exchange to postpone paying capital taxes indefinitely.
In fact, many real estate investors use 1031 exchanges to continually roll profits from each property into ever-larger income properties, never paying a cent in capital gains taxes until the day they decide to sell off their portfolio. A day that never comes for some lifelong investors.
As you explore ways to lower your taxes as a real estate investor, add 1031 exchanges to your tax-shrinking toolkit.
What Is a 1031 Exchange?
Not-so-creatively named after the section of U.S. tax code that details it, 1031 exchanges allow investors to “swap” one property for a similar property without paying capital gains taxes on the sold property. It initially applied when two parties swapped properties with one another, but nowadays 1031 exchanges are mostly used when investors sell off a property then use the proceeds to buy another from a different seller.
Investors defer or postpone paying capital gains taxes until they sell a property without buying a new replacement property.
Historically, citizens could perform a like-kind exchange on any type of personal property, such as franchise licenses, aircraft, and equipment. However that changed under the Tax Cuts and Jobs Act of 2017, which no longer allows 1031 exchanges for personal property. Only real estate qualifies under the new tax rules.
The Real Estate Strategy Behind 1031 Exchanges
When you first start investing in real estate, you probably don’t have much cash. You might buy a small rental property that generates $150 a month, and set about saving up more money.
After a few years, you’ve saved up more cash and built some equity in your rental property. You decide to upgrade to a three-unit property that generates $500 per month.
So you sell your single-family rental, and combine the proceeds with your savings to buy the new three-unit property. With a 1031 exchange, you defer paying capital gains taxes on your profits from selling the single-family rental.
A few years later, you repeat the process, selling the three-unit property and buying a six-unit property that cash flows $1,000 per month. Again, you defer paying capital gains taxes on the three-unit building you sold by using a 1031 exchange to roll the profits into the new purchase.
Then you do it again to buy a 15-unit apartment building that generates $2,500 per month. Then a 30-unit complex, then a 50-unit complex, and then you retire with $15,000 per month in net rental income.
In short, you keep snowballing the profits of your real estate to trade up to ever-larger buildings with greater cash flow. All without paying a dime in capital gains taxes as you upgrade from one property to the next.
1031 Exchange Requirements
To qualify for a 1031 exchange, both you and your real estate deal have to meet certain criteria. That criteria starts with the simple rule that investments must be “like-kind,” meaning both properties involved must be investment properties.
Keep the following in mind before you commit to any 1031 exchange plans.
Available to Investors Only — Not Homeowners
Like-kind exchanges are not available to homeowners, only to real estate investors.
Before you cry foul about how real estate investors get unfair tax breaks, this rule exists for a good reason: homeowners don’t need it. They already benefit from the homeowner exclusion, which exempts them from paying capital gains taxes on the first $250,000 of profits ($500,000 for married couples) when selling their home.
In other words, most homeowners don’t pay capital gains taxes when they sell their home anyway.
Equal or Greater Value
To capitalize on the 1031 exchange tax break, the new property you buy must cost at least as much as the property you sold. Otherwise, investors could scale down their portfolios without paying taxes either.
If you buy a replacement property at a lower price, you get taxed on the difference in value. More on taxable “boot” shortly.
Applies to Income Properties, Not Flips
The 1031 exchange was designed for long-term investments, not rapid house flipping. Specifically, the IRS rules state that you can’t exchange properties “held primarily for resale.”
Like-kind exchanges help you postpone or avoid long-term capital gains taxes — which apply to assets held for at least a year — not regular income taxes on short-term profits. If you want to use a 1031 exchange, hold your property for at least a year before selling it.
There are two time limits you need to remember when doing a 1031 exchange.
After you sell your old property, you have 45 days to declare a new replacement property. Known as the 45-day rule, you have to submit the details about your upcoming property purchase to a qualified intermediary (middleman — more on that shortly). The IRS does recognize that sometimes deals fall through however, so they allow you to specify up to three potential properties.
This raises the second time-based rule: the 180-day rule. You have up to 180 days to settle on the new property after you sell your original property.
Note that the clock starts ticking on both time requirements from the day that you close on selling your first property. The 180-day rule starts then, not when you declare your new property or submit your property options, as the case may be.
Qualified Intermediary Must Hold Funds
When you do a 1031 exchange, you can’t touch the profits from the relinquished property. You need to pay a disinterested third party — a qualified intermediary — to hold the money for you in escrow between when you sell one property and buy another.
In fact, the qualified intermediary must actually buy the new property on your behalf, and then transfer the deed to you afterward. There are no licensing requirements to become a qualified intermediary, but you can’t use a parent, child, spouse, or sibling. You also can’t use someone already serving as your “agent,” such as your real estate agent, accountant, or attorney.
Some banks, such as Wells Fargo, offer to serve as a qualified intermediary on your behalf, but beware they charge a fee.
Boot, Debt, and Cash
If you have cash left over from the sale of your old property that doesn’t go toward buying the new property, the qualified intermediary returns it to you 180 days after you closed on selling the old property. Known as “boot” based on the old English word meaning “something in addition to” — today rarely used outside the expression “to boot” — the IRS taxes this surplus cash as capital gains.
Straightforward enough. But beware that boot covers not only the cash you receive, but the difference in debt levels.
Say you sell a property for $300,000, of which $200,000 goes toward paying off a mortgage, and the other $100,000 goes to the qualified intermediary to help fund the replacement property (ignoring closing costs for simplicity). The boot principle applies not just to the $100,000 in cash, but also to the $200,000 in debt.
Remember, to avoid capital gains taxes on the sold property, you need to buy a replacement property of equal or greater value. You can’t go out and buy a property for $100,000 just because that’s your cash payout after selling the old property. Or rather, you could, but you’d still owe Uncle Sam capital gains taxes.
To avoid any capital gains taxes, the new property must cost you at least what you sold the old property for — in this case, $300,000.
How Depreciation Fits In
Real estate investors can depreciate the cost of the building and some closing costs for the first 27.5 years they own a property. In other words, depreciation refers to a tax deduction that the taxpayer spreads over multiple years rather than taking all at once. They can also depreciate the cost of any capital improvements, although the period varies.
When investors sell a property, they have to effectively pay the IRS back for the depreciation deductions they took. Known as depreciation recapture, the IRS taxes you at your regular income tax rate for it.
Fortunately, you can dodge depreciation recapture just like capital gains taxes using a 1031 exchange. That is, if you swap two like-kind properties that both have buildings on them. If you buy a piece of raw land with no building on it, you still owe depreciation recapture because it’s the building that’s depreciated. Speak with a tax professional because these quirks can quickly cause confusion and tax errors.
1031 Exchanges and Personal Use Properties
The IRS makes it clear: 1031 exchanges exist for investment properties, not personal residences. Still, the real world is a messy place, and sometimes property owners change the use of their properties.
Converting a Second Home Into a Vacation Rental
The IRS allows you to use a 1031 exchange to defer capital gains taxes when you sell it, if you meet two conditions:
- For each of the last two years (measured as 12-month periods, not calendar years), the property was rented at fair market pricing for 14 or more days, and
- You limited your own personal use of the property to the greater of 14 days or 10% of the number of days that it was rented at fair market pricing within each 12-month period.
Note that you must use the property primarily as a rental for at least two years before you can do a 1031 exchange on it.
Converting a Rental Into Your Residence
The reverse also holds true if you want to convert the new property into your primary residence in order to take advantage of the $500,000 homeowner exclusion.
After you perform a 1031 exchange to swap one investment property for another, you can’t move into the new property for at least two years. Specifically, the property must be fair-market rented for at least 14 days in each of those two years, and you can’t use the property yourself for more than 14 days in each of those years or 10% of the days it was rented.
If you wait those two years and use the property as a rental, you can then move in, but you must live there yourself for at least two years before you can take advantage of the primary residence exclusion. So yes, you can theoretically roll your capital gains into an eventual residence and dodge the first $500,000 in taxes on them, but it involves a lengthy multi-step process to pull off.
Does a 1031 Exchange Make Sense for You?
Deferred exchanges work marvelously for a specific type of investor looking to roll their gains into ever-larger properties with greater cash flow. Even if you fit that description, however, they don’t always make sense.
First, it could be unnecessary. If you take capital losses elsewhere one year, they offset your capital gains. For example, say you sell some stocks for a $30,000 loss, and you sell your rental property for a $35,000 gain. The IRS would only hit you with capital gains taxes on the net gain of $5,000 — hardly a tax scenario to spill tears over.
For that matter, you can actively harvest losses to offset your capital gains.
You should also consider your own cash needs. Sure, it’d be nice to avoid capital gains taxes, but if you need the money for another use rather than buying a new investment property, that could take precedence.
For instance, say you sell a property for a $35,000 gain, but you incur $20,000 in medical expenses. Or you desperately need a new roof, or you need to pay off your degenerate brother-in-law’s debts to the mob so he doesn’t swim with the fishes. You get the idea: tax optimization is great, but only to the extent that it fits with your other financial needs.
As real estate tax perks go, 1031 exchanges fall on the more complex end of the spectrum. Don’t approach them cavalierly, and speak with a financial professional before attempting your first one.
Still, they offer a fantastic opportunity to scale your investment portfolio without having to pay capital gains taxes along the way. If you hope to generate ever-growing income from real estate investments, consider swapping out your lesser cash-flowing properties for greater ones and deferring capital gains taxes for another day.