Updated: May 4, 2022
Want to know how to profit using 1031 exchanges?
According to CNBC, around 90% of millionaires used IRS 1031 Tax-Deferred real estate exchanges to build their wealth. How did they do it?
The wealthiest Americans used Internal Revenue Code Section 1031 Like-Kind Exchanges to build their wealth. That’s because an IRS 1031 Exchange lets you defer your capital gains taxes from every sale of a business or investment real property. Simply sell the real property and use the sales proceeds to buy similar replacement property.
Is it that simple? Almost, but you must follow a few rules.
The 1031 exchange law allows complete capital gains tax deferral when you sell any business or investment real property and buy other business or investment properties.
There is no limit to how frequently you can do 1031 exchanges.
When you pass away all heirs inheriting your 1031 properties can legally avoid paying estate and capital gains taxes.
Here’s How to Profit Using 1031 Exchanges
Before explaining the rules, let’s examine what a 1031 property is.
1031 real property – Real properties used in a 1031 exchange are business or investment properties. However, the IRS prevents “real estate dealers” who buy and flip houses quickly from using 1031 exchanges. Thus, tax experts recommend holding investment properties at least for “one year and a day” before starting a 1031 exchange.
Raw land held for investment purposes;
Renting single or multi-family homes, condos, or apartments buildings;
Industrial properties; and any other
Business or investment property.
What’s a 1031 Exchange?
1031 exchange – The 1031 exchange law sets up a legal process for selling one or more business or investment properties. Then, using the sales proceeds to purchase more business or investment properties.
Capital gains tax – The profits made from the sales of these properties are called “capital gains” and taxed by the federal and most state governments.
Deferred capital gains tax – The 1031 exchange law defers all capital gains taxes when the sales proceeds buy any “like-kind” properties. Deferring capital gains taxes amounts to big savings for the taxpayer.
What are the Rules for a 1031 Exchange?
Typical of tax laws, you must follow several rules to qualify for the capital gains tax deferral. Don’t worry. These rules are clear and easy to follow.
Rule 1: You must Exchange “Like-Kind” Properties
Luckily, “like-kind” does not mean exactly alike. As mentioned above, you can exchange any business or investment property for another or more. You can mix and match any of these properties. For example:
Selling an apartment building and buy (exchange) different business or investment properties like a commercial building, shopping mall, or raw land to hold as an investment;
Sell investment raw land and buy a single-family home rental and a retail store or a gas station; or
Sell a commercial building and buy multi-family rental properties or a warehouse.
Rule 2: Your Sales Proceeds Must Be Held by a Qualified Intermediary
A Qualified Intermediary (QI) is a neutral company or person who holds your sales proceeds in an escrow account. When you find properties to buy, the QI uses the same funds to buy them. This way you never control or own the proceeds. That’s why it's called an “exchange”.
Beware: Touch or control the money in any way and the IRS will declare the exchange as a normal sale and purchase where the sales proceeds are subject to the capital gains tax.
Rule 3: You Must Buy Properties Equal or Larger Value to the Ones You Sold
Deferring all your capital gains taxes using a 1031 exchange requires buying replacement real properties totaling an equal or larger value than what you sold.
If you are left with unused sales proceeds the IRS calls it “boot” making you pay the capital gains tax on the boot. Tax experts refer to this as getting the “boot” from the IRS.
Rule 4: The Replacement Real Properties Must Carry Identical or Greater Debt
Along with identical or greater value whatever pre-existing debt on the sold properties must appear on the replacement real properties. Paying off debts on the replacement real properties not secured by a mortgage or deed of trust is considered “boot” by the IRS subject to capital gains tax.
The American Bar Association explains paying off debt on 1031 exchange replacement properties. When you sell property that contains debts (mortgage, deed of trust, equity loans, etc.) at least the same amount of debt must appear on the replacement real properties. Using the sales proceeds to increase your equity by paying off replacement property debts is a taxable gain (boot).
Rule 5: Identify Replacement Properties within 45 Days
The IRS requires specific time limits during the exchange process. When the sale of each business or investment property closing occurs you only get 45 days to identify the potential replacement properties. This is called the “45-day rule”.
This means you must create a list identifying three potential properties you are considering buying. You must date and sign the list and give it to your QI. To prove the date, it's best to have a notary public witness you’re signing and verify the date. The IQ holds onto the list in case the IRS ever asks for it.
Considering more than three? The IRS lets you identify more properties as long as their combined value does not exceed 200% of your original property’s value. For instance, you sell a $200,000 rental home and identify $400,000 worth of replacement properties.
Note: You don’t have to buy all the properties. Just make sure that whatever you buy is on the list.
Rule 6: You must Close on Your Replacement Properties within 180 days
The IRS gives you 180 days from the closing of your sold property to close on your replacement properties. This is called the “180-day rule”.
Beware: Closing past the 180-day deadline results in a failed 1031 exchange and owing capital gains taxes.
Other rules exist, but these are the most important ones.
What Does the 1031 Exchange Process Involve?
Here are the 8 steps you will need to take to complete a 1031 exchange:
Consult with your Realtor about the value of your business or investment properties;
Sell your qualified exchange property;
Hire a qualified intermediary (QI);
Transfer the sales proceeds to your QI;
Within 45 days of the closing identify your potential replacement properties;
Buy your replacement properties;
Within 180 days of the sale’s closing close on your replacement properties; and
Report your exchange to the IRS using Form 8824.
🟢 Basic Benefits of a 1031 Exchange
Besides deferring the capital gains tax, a 1031 exchange helps you:
Sell raw land for income-producing properties;
Diversify your assets with different replacement properties;
Buy replacement properties for better returns;
Make your estate planning easier by consolidating several small properties into bigger ones; and
Step up from self-managing your current properties to bigger ones and use a professional property management company. If you own rental properties in San Diego County, we recommend WeLease Property Management Company.
🟢🟢 Bonus Benefits of 1031 Exchanges
Even bigger benefits exist than the basic ones. Asset Protection and Estate Planning Tax experts reveal the greatest benefits for doing 1031 exchanges.
Defer Capital Gain Taxes Forever
Yes, you can continue doing tax-deferred exchanges until you die. Then, all your capital gains taxes go away when your heirs take ownership of the properties. Here’s why:
The American Bar Association explains what many experts call a big loophole in the IRS 1031 Exchange laws.
Basis – Capital gains taxes are determined by the “basis” in a property. It’s another way to describe the calculation of equity and profit. The total costs and expenses for buying and maintaining real properties are called the “tax basis” or “cost basis”.
How does cost basis determine capital gain? – When you sell a business or investment property the sales price minus the cost basis
determines the capital gain. Here is a formula:
Cost Basis = Purchase Price + Costs & Fees Replacement Property’s Sales Price minus Cost Basis = Capital Gain
Example of cost basis determining capital gain using these facts.
Your first 1031 exchange sale is a rental property with a sale price of $200,000. You incurred expenses buying the rental (like escrow and loan fees). Over the years, you paid for improvements and maintenance. When you sold it, you paid a real estate commission, escrow fees, attorney fees, etc. All those costs are added to your original purchase price. Let’s say the new cost basis is $250,000. You sell it for $350,000. Here is the calculation:
Sale Price = $350,000 Cost Basis = $250,000 $350,000 minus $250,000 = $100,000 Capital Gain
Explanation of Carryover and Step-Up Rules
Cost basis carryover – When you exchange, the original tax basis in the sold properties “carry over” into the replacement properties. As you keep selling and exchanging the tax basis increases with each gain.
Cost basis step-up – When your heirs inherit your properties the IRS adjusts the value to its current market rate. This step-up cost basis is like your heirs paying for the entire value to acquire the properties. Therefore, they don’t owe any capital gains tax if they sell at that value.
Example – You started with a $100,000 basis in your first exchange and years later when you pass away your basis is $1 million. If your heirs sell the properties for $1 million, they do not make a taxable gain. Also, they don’t pay the federal estate tax because of the step-up cost basis.
You legally defer the capital gains taxes while you live and your heirs legally avoid the estate tax and the capital gains tax too.
How to Profit Using 1031 Exchanges – Conclusion
You just read how to profit using 1031 exchanges. Also, how to legally avoid paying capital gains taxes. Likewise, your heirs also legally avoid paying the capital gains tax and the estate tax.
Every business and investment real property qualifies for a 1031 Tax Exchange;
The IRS 1031 Tax-Deferred Exchange law lets you sell any business or investment real property to use the sales proceeds to buy more business or investment properties; and
The IRS 1031 Like-Kind Exchange law offers more tax benefits to real estate investors than any other tax law.
Follow these 6 steps to qualify for a 1031 exchange:
1. Only exchange “Like-Kind” properties;
2. A Qualified Intermediary holds the sales proceeds;
3. You must buy properties of equal or greater value than the ones you sold;
4. Your replacement properties must carry equal or greater debt;
5. Identify your replacement properties within 45 days from the sale closing; and
6. You must close on your replacement properties within 180 days from the sale closing.
Want to Sell and Exchange Rental and Investment Properties in San Diego County?
SoCal Lifestyle Realty not only publishes blog posts to educate sellers. We offer services from our experienced Realtors to help you benefit from 1031 Exchanges in San Diego County.
Contact us to learn more about the benefits from 1031 Like-Kind Exchanges to prosper and leave a legacy for your family to prosper too.