The Art of the 1031 Exchange

Have you ever wondered how some people are able to own multiple rental properties, expand their portfolios, and grow their wealth — all while making it look effortless?

I strive to help all of my clients, friends and family save money while simultaneously growing their wealth — so in this article I’m addressing a well-known secret in the IRS Code: the 1031 Exchange. 

I say well-known because many people have heard of these exchanges (also referred to as like-kind), however few people utilize them to their full advantage. 

After reading this article you will be more aware of what a 1031 exchange is, what it entails, and will have the knowledge to utilize the tax advantages of the 1031 in your future. 

A 1031 Exchange allows you to sell your rental property in exchange for another one, while deferring (or postponing) the capital gains tax on the sale of the first property.  

“1031” is the actual section of the Internal Revenue Code that this exchange rule refers to. It essentially allows the investor to trade up the proceeds from one rental property into another and defer the capital gains on the property that was sold — which allows you, the investor, to pay the IRS as little as $0 in tax upon selling the first property.

Here is an example: 

You purchased a rental property (property A) in 2018 for $500,000. To date you have taken $50,000 in depreciation expense and the rental property is now worth $750,000 (sales price). You found a duplex across town (property B) for sale at $1,000,000 that you want to purchase and rent out. However, you need to sell property A in order to pay for property B. 

If you sold property A and took the cash out on the capital gain, you would pay capital gains tax on $300,000 ($750,000 - $500,000 - $50,000), paying approximately $60,000 in Federal tax (assuming 20% capital gains rate) + your state tax rate.  However, if you simply exchange property A for property B, you could defer all the capital gains (both fed & state) into the new duplex, deferring the $60,000 in Fed tax + the state tax that would have been owed. You would reduce your basis in property B by $300,000 (deferred gain on sale), making the duplex basis $700,000 (not the $1,000,000) and when the duplex is sold the $300,000 is recognized as a gain at that time. Therefore, it could be many years before the tax on property A is actually paid to the government.  Thus, allowing you to take the $60,000 + to invest in either the duplex, or other investments, as opposed to paying it straight to the government.

While that all sounds great, there are some very strict rules when completing a 1031 exchange:

1.       The owner (seller) can not touch the cash from the sale of property A.

2.       The new property must be identified within 45 days of selling the first property.

3.       The 1031 exchange must be completed within 180 days of the sale of property A.

4.       The properties must be like for like. (This means that an investment or commercial property can be exchanged for another real estate property for the same purpose. Hence in our example a single-family residence traded for a duplex.)

5.       The proceeds from the sale of property one must be transferred through a qualified intermediary.

A 1031 exchange is an under-utilized tool that can help you save taxes, build wealth, and expand your portfolio.

Please contact your CPA and realtor for specific guidance in completing your 1031 Exchange to ensure it is completed properly. 

*This article is meant as an informative overview.