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You've probably seen on the news or heard from other investors that there is so much equity in real estate right now. In fact, it's a great time to invest in real estate.
But the question is: why should you consider real estate? The answer, which may surprise you, is taxes.
As doctors, we love to talk about tax strategies. How can I save more next tax season? What other strategies can I use to keep more of my income in my pocket? The pain of tax season can be eased by investing in real estate and taking advantage of many of the tax breaks that come with it. One powerful tax advantage in real estate is the 1031 exchange.
You could be in a perfect position to advance your financial goals with a 1031 exchange. It's a tax strategy that can be critical to building wealth and your future as an investor and/or entrepreneur.
Stock markets offer some tax-efficient strategies that may offset capital gains and put more money in your pocket come tax season. By saving, investing, and compounding your income, you have more opportunities to do what you love: vacations, family time, your passions, or any goals that are worth your time and money.
But are they too good to be true? Today we'll learn more about 1031 exchanges, how they affect your real estate investments, and how you can use them to put more income in your pocket!
What is a 1031 exchange and how does it work?
As a tax strategy, a 1031 exchange allows real estate investors to defer capital gains tax on the sale of an investment property when another, like-kind property is purchased. It is a legitimate provision in the U.S. tax code (Section 1031) that essentially allows you to exchange one investment property for another without paying capital gains tax.
There are some rules and restrictions on what types of assets you can use the 1031 exchange for. For example, the new property must be used for business or investment purposes. For deferred exchanges—the most common type—the new property must be identified as a target for a 1031 exchange within 45 days of the sale of the old property. Additionally, the new investment property must be sold within 180 days of the closing of the sale of the relinquished property. Be sure to work with your real estate agent, CPA and financial team to carefully consider whether exchanges are a good fit for your financial plan.
When you initiate an exchange, report it to the IRS using Form 8824. But don't get me wrong. When I talk about taxes, I need to be clear: I am not a tax professional. I just use the strategies I learn from my own tax professionals. Always consult your accountant or financial team to ensure your investment decisions are consistent with your financial goals.
What is similar property?
A like-kind property can be characterized as two property assets that can be held for investment, trading or business purposes of a similar nature. Typically, this means that the newly acquired investment property must be of equal or greater value than the property being sold or relinquished.
“Like-kind” doesn't mean it has to be an exchange of the same asset class. Of course, you can exchange a single-family home for a single-family home. But you can also exchange a multi-family home for land, land for industrial or office space, industrial for mineral rights, or anything in between. But make sure the relinquished and replacement properties meet the requirements for a tax-free exchange.
There are some restrictions. For example, the new investment property cannot be your primary residence and must be located in the United States.
The advantages of investing in similar properties
By deferring your capital gains taxes, you now have more money to invest as you wish. The compounding effect of tax-free investments gives you the opportunity to boost your portfolio's performance and reach your financial goals more easily.
Another fantastic aspect of this strategy is that there are no limits to the number of exchanges you can initiate. This means you can continually increase the value of your real estate investments while deferring your capital gains. You could start with a single-family home, exchange it for a duplex, then for a multi-family home, and end up with an even larger multi-family complex.
And for those looking to build a legacy, 1031 exchanges offer great benefits for heirs – an opportunity to create multigenerational wealth. There is something called step-up basis for heirs of real estate investments when the owner of the property dies. What is step-up basis? This means that whoever inherits your property “buys” (inherits) it at the property's appraised value as soon as they inherit it. This would eliminate any taxes the original owner would otherwise owe from capital gains and appreciation. They could sell the property the same day, tax-free.
Types of 1031 Exchanges
Delayed exchange
As the name suggests, these 1031 exchanges give you 45 days to find a replacement property and 180 days to complete this new investment. They typically occur when the relinquished property has already been sold and closed on before the new investment property is purchased.
The main advantage of this type is that you have more time to find your new investment property. And finding the right property to swap can be difficult. It may not surprise you that this is the most common type of swap because of this time advantage.
Intermediate exchanges
In an interim exchange, a qualified intermediary (QI) helps the investor initiate and complete a 1031 tax deferred exchange in a timely manner. They prepare and manage the exchange and legal documentation, hold the proceeds of the exchange in an escrow account, and work with the title company.
QIs are not always required, but they offer many benefits. In some cases, such as an exchange with more than three parties, QIs are a required part of the process. They are a neutral party whose only incentive is to do a good job for their clients and earn their exchange fee.
Other, less common 1031 exchanges
Sometimes you may want a partial 1031 exchangewhich allows a property owner to defer payment of taxes on a portion of the capital gains from the sale of his property.
There is also a simultaneous 1031 exchangealso known as a “drop and swap” exchange, where the closing of the relinquished property and the replacement property occur on the same day. This helps an investor reinvest their money quickly without delaying the process for 45 or 180 days, as with a delayed exchange. However, as you can imagine, coordinating a simultaneous exchange can be very difficult and complex.
With a reverse 1031 exchangean investor would first purchase the replacement property before selling the existing property. This option requires the investor to have the financial means to purchase the replacement property without having the proceeds from the property being sold. The main advantage here is that the investor has the ability to set up an exchange without having to sell existing properties first.
Finally, there is a special type of exchange, the so-called construction or Improvement 1031 ExchangeIn construction exchanges, the investor can use the exchange funds to build a new property, while in improvement exchanges, the investor can use a portion of his exchange funds to make improvements to an existing property.
Each of these less common 1031 exchanges can access more advanced tax strategies. We'll discuss this in more detail in an upcoming blog.
Acquisition of similar investments
When you're ready to get started, find a property that works well as an investment while also fitting your financial plan. I write a lot about what makes a good investment property, but some important things to think about are asset class, location, and due diligence.
Know your schedules. Schedules indicate when certain parts of the buying and selling process are triggered. If you miss them, you could miss the entire exchange.
When engaging the services of a QI, make sure you choose the right one. One method is to ask your colleagues with experience in 1031 exchanges which QI they have chosen. You can also engage in your investment communities to crowdsource a QI with a good reputation.
When you find a provider, research them carefully before moving forward. Do they have experience in real estate? Have they passed compliance audits such as SSAE 16? Do they provide regular access to funds? Are your funds FDIC insured?
When does a tax-advantaged 1031 exchange make sense?
The right time for a 1031 exchange is when the new property has a better return on investment (ROI) than the existing property(s).
But there are other timing considerations. If you own multiple properties that you want to trade together for something larger, you can consolidate multiple properties into a single exchange. And the reverse is also true: It may make sense to sell one of your current properties to invest in several new properties.
Barter transactions can also serve as a hedge against a bad investment. Perhaps a rental property experiences an unexpected loss in value. One way to roll back that investment? A 1031 exchange. This is how the IRS allows you to write off a large amount of value — called “book losses.”
Leverage the power of the 1031 exchange
I hope that with a little more understanding of 1031 exchanges, you will feel more comfortable considering them as a powerful investment and tax deferral strategy. I have used them and they have significantly improved the performance of my investment portfolio.
But that's not the end of our discussion on 1031 exchanges. Stay tuned to this blog. Soon we'll be diving deeper into specific types of 1031 exchanges and advanced strategies for how you can use them as an investor, including more fine-tuned tax implications.
Until then, I hope you engage in our communities here at Passive Income MD and continue to invest to achieve your ideal life!
Peter Kim, MD, is the founder of Passive Income MD, the creator of the Passive Real Estate Academy, and provides weekly training through his Monday podcast, the Passive Income MD Podcast. Join our community in the Passive Income Doc Facebook group.
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