There are many ways to make money in real estate such as price appreciation, leverage, cash flow, tax write-offs, depreciation, etc. However, one of the greatest advantages of continuously investing and reinvesting in real estate is the 1031 Exchange, which enables people to keep deferring tax payments on real estate gains.
For instance, if you buy a property for $400,000 and sell it for $600,000 you normally would need to pay a capital gains tax on the profit of $200,000. This is usually a 15% federal tax, not counting paying income taxes. Also, if you live in a state like California, you will need to pay about a 10% state income tax. Also, your profit may put you in a higher income bracket, which means a higher tax rate. Therefore, if you make a profit of $200,000, you may end up paying about 30%-40%, or about $60,000 or more in taxes.
However, if you engage in a 1031 Exchange, you can defer payment of the tax. Basically, the tax code encourages investors to continuously reinvest their profits in real estate and trade-up to more valuable properties. Here’s how it works:
- Profit: You make a nice profit on an investment property you just sold. Let’s say your profit is $200,000.
- Intermediary: You designate a Qualified Intermediary (QI) to facilitate the 1031 Exchange. Qualified Intermediaries are companies specializing in 1031 Exchanges. Once hired, these companies will receive your $200,000 profit from escrow and hold it for you until you’ve purchased a replacement property. You never actually get a hold of your money. The Qualified Intermediary receives the money and releases it on your behalf to the seller of the property that you purchased.
- Identifying Replacement Property Candidates: You have a maximum of 45-days after selling your property, to identify a list of possible replacement properties. You must state the address of each potential replacement property.
- Completing the Purchase of Replacement Property: You have a maximum of 180-days to actually close escrow on one or more of the replacement properties that you previously identified.
- Tax Deferment: As a result the above process, you get to avoid paying any taxes on the gain from your real estate sale. In this example, you just deferred tax payments on a profit of $200,000.
- Investment Properties Only: 1031 Exchanges are not for primary residences or vacation homes. You can probably avoid any taxes on the sale of your primary residence, but that’s another topic for another day.
- Like-Kinded Property: This usually means that the replacement property must be equal or greater in value than the property you sell. For instance, if you sell your property for $600,000, then the price of your replacement property must be $600,000 or more. Basically you cannot trade-down.
- Boot: If you use only a portion of your profit to purchase another property, you will be taxed on the amount you didn’t use. For example, if you realize a gain of $200,000 on the sale of your property, but only use $175,000 towards the purchase of a replacement property, then you will need to pay taxes on the $25,000 gain that you captured.
- Other – Replacement Properties Criteria:
- The Three-Property Rule – Up to three properties regardless of their market values. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
- The 200% Rule – Any number of properties as long as the aggregate fair market value of all replacement properties does not exceed 200% of the aggregate Fair Market Value (FMV) of all of the relinquished properties as of the initial transfer date. All identified properties are not required to be purchased to satisfy the exchange; only the amount needed to satisfy the value requirement.
- The 95% Rule – Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified. In other words, 95% (or all) of the properties identified must be purchased or the entire exchange is invalid.
The main benefit of a 1031 Exchange is the ability to keep trading up the value of properties you acquire. Many investors start with small properties, but keep buying more expensive/valuable properties with their tax-deferred money.
Disclaimer: The above does not constitute any advise. Please check with your own CPA, accountant or financial advisor.