Despite the changing economy, real estate remains one of the most reliable ways to build wealth. The downside to that is, the more wealth you build, the more taxes you usually have to pay. For many, finding legal ways to lower taxes is an ongoing hunt. Surprisingly, the government has actually given active real estate investors a very simple—and legal—way to defer capital gains tax on real estate transactions. Yet many seasoned investors don’t use it. Why not? For the most part, it may be because a lot of people aren’t aware of it.
What is the 1031 Exchange Tax Deferral?
The 1031 exchange tax deferral allows real estate investors to defer taxes by selling and then buying more properties within a certain time frame, and which fall into certain categories. In a traditional real estate transaction, you might buy a property, wait for its value to appreciate, then sell it at a profit. You’d then pay taxes on the profit. Those taxes can really take a bite out of your profit; plus they reduce the amount of money you have to invest in another piece of property. This can really hold you back as far as wealth building.
With the 1031 exchange, you buy and sell a property as usual, but instead of paying taxes on the profit, you defer taxes by following the next steps and rules set up in the tax code. The rules include:
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Hold the property for about a year to demonstrate your investment objective
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Identify between one and three properties to buy within 45 days of selling the old property
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Close on the new property within 180 days of selling the old property
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The new property has to be a like-kind property, such as a single family home and a single family home, or an apartment building and an apartment building
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Buy and sell properties in one name only
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Never take personal possession of the funds at any point in the transaction (use an intermediary to facilitate this)
As long as you follow the guidelines, the buy, sell, buy transactions qualify as a 1031 exchange and you can defer taxes on the sale. In fact, you can keep doing this as many times as you want during your lifetime. When you pass on, your heirs won’t have to pay taxes on those sales, either. If they sell your current property, they only pay tax on the current market value. Essentially, this gives you perpetual deferred taxes.
Mistakes to Avoid
There are a number of very strict rules with the 1031 Exchange. Following are some of the most common reasons transactions end up being disqualified for Section 1031 benefits.
Offering Cheap Rent to Family Members
The 1031 exchange rules don’t prohibit you from renting out your investment property to family members or friends. Collecting rent from anyone deems it a bona fide investment. However, in order to avoid getting disqualified, you’d have to charge fair market value for the rental. That means no breaks of any kind for your beloved son/daughter, etc. The IRS may look closely at your 1031 transactions, so be sure to actually collect that fair market rent, too, so you can show receipts and deposits if you’re audited.
House Hacking
Duplexes are real property and so qualify under the 1031 exchange rules. But primary residences don’t qualify. If you’ve purchased a duplex or another multi-unit investment property and you plan to live in part of it while you rehab the other part, it then becomes a primary residence. This disqualifies your transaction for the 1031 exchange benefit.
Forming a Business Entity
One of the caveats of qualification is that the title of both properties must be in the same taxpayer’s name. So if you buy a rental under John Smith, the purchase of your replacement property must also be in the name of John Smith. Now, let’s say that you make a killing on your rentals and you decide to form a company out of this real estate investing business. You name your business John Smith, Inc., because you’re aware of the IRS 1031 rule. But John Smith the individual taxpayer is not the same as John Smith, Inc., the taxpaying company. Come tax time, you’re going to owe the capital gains tax on the sale of that first property. Another scenario would be if you buy an investment property yourself and then you get married and decide to add your spouse to the title and then from there on out you purchase 1031 exchange properties in both your names. Technically, you could be disqualified on the grounds that your spouse’s name wasn’t on the original title. The safest thing is to keep the names on all your titles identical, including spellings, nicknames and suffixes like jr. and sr. You can use any taxpayer entity you like, but it must remain constant throughout all your 1031 exchanges.
Investing Overseas
You can certainly buy a vacation rental property overseas and maybe get a nice return, but it won’t qualify as like-kind under Section 1031. As stated by the IRS, “…real property in the United States is not like-kind to real property outside the United States.”
Disguising a Fix and Flip
The 1031 exchange is not permitted for fix and flips. It’s intended for investment properties; “real property held for productive use in a trade or business or for investment.” Most investment properties need at least some rehab before they can cash flow. It’s fine to fix up your investment rental property so you can get the highest possible rent. What isn’t fine is to buy a distressed property, fix it up and then pretend to try to rent it out just long enough until you can flip it and do a 1031 exchange. This is the reason why most CPAs recommend holding your 1031 investment properties for at least a year before doing the 1031 exchange.
There are lots of rules regarding the 1031 exchange; many of them time-sensitive. While it may feel scary to attempt to do 1031 exchanges, remember that with the guidance of a qualified CPA and an intermediary, it’s perfectly safe and legal. Don’t miss out on this opportunity to defer capital gains tax indefinitely on your real estate investment properties.
by Kate Supino