1031 Exchange: How to Reduce Taxes When Selling Investment Real Estate

Investment real estate is a wonderful way to build wealth over time. This is a strategy that has been successful for many of our clients over the years. There are many benefits to owning real estate investment properties. These include the ability to create a passive income stream, various tax benefits and of course wealth creation as the value of your investment properties increase over time. But what happens if a property you own no longer is a good fit for your long-term real estate investment strategy?

Tax Issues

The tax consequences of selling highly appreciated investment property can be severe and can greatly reduce the long-term gains experienced over time. Unlike your personal residence, you do not get the section 121 exclusion. This allows you to exclude up to $250,000 of gains per person so long as you have lived in the property for two of the last five years.

One of the major advantages to owning investment real estate is the ability to depreciate it over time. This helps from a tax perspective, but it serves to lower your cost basis in the investment property, increasing your gain when you go to sell it. In fact, when you recapture depreciation, it’s taxed as ordinary income tax rates. The tax consequences for selling highly appreciated investment properties can be severe.

So, what do you do if you need to sell an investment property? This may occur for several reasons in fact. You may decide that you no longer want to be a hands-on real estate investor. The market demographics for your property’s location may have shifted or changed, making the property a less desirable investment moving forward. Or perhaps you are moving out of state for retirement and don’t want to be a long-distance owner and property manager.

1031 Exchanges

If you find yourself facing any of these circumstances, there is a great tax saving opportunity in the US tax code known as a 1031 exchange. This is in reference to line 1031 of the tax code. It allows you to sell your investment property and defer all of the taxes on the capital gains to the future.

There are several important facets of the rule that you must understand in order to use this strategy to your advantage. First, the exchange must be of a “like-kind.”

What Is a Like-Kind Exchange?

A like-kind exchange is a tax-deferred transaction. It allows for the disposal of an asset and the acquisition of another similar asset without generating a capital gains tax liability from the sale of the first asset. Click here for more IRS guidance.

This essentially means an investment property must be exchanged for another investment property. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But there are landmines to be wary of.    

Qualified Intermediary

In most circumstances, the use of a qualified intermediary is required to successfully complete an IRC Section 1031 tax-deferred exchange. A qualified intermediary is sometimes referred to as an accommodator, facilitator, intermediary or QI. Their role is to receive the cash from the sale and act as the “middleman” to facilitate the 1031 exchange. The use of an experienced qualified intermediary can significantly reduce the chance that something major can go wrong with the exchange, negating some or all of the potential tax benefits.    

The 45 Day Rule

You must identify the property or properties you wish to purchase within 45 days from the close of escrow on the investment property you sell. You must designate the replacement property in writing to the intermediary, specifying the property you want to acquire. The IRS says you can designate three properties so long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.

The 180 Day Rule

The second timing rule in a 1031 exchange relates to closing. You must close on the new property within 180 days of the sale of the old property.

You are essentially swapping one investment property for another. The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred. There’s no limit on how many times or how frequently you can do a 1031. You can roll over the gain from one piece of investment real estate to another, to another, and another. Sometimes, you may hear savvy real estate investors refer to the strategy as “defer, defer, defer die.” Oftentimes, you see real estate investors continue to do 1031 exchanges on their properties until they die, and their children inherit the assets. Under current law, the “step up in basis “applies thereby allowing your children to inherit the investment property tax free.

Both the 1031 exchange rules as well as the step up in basis rules are coming under fire in Washington. We are paying very careful attention to any changes that may occur in the near future. Such complications are why you need professional help when you’re doing a 1031.

Tax Implications: Cash and Debt

At the end of the 1031 exchange, you may have some cash left over after purchasing the replacement property. If this occurs, the intermediary will pay you at the end of the 180 days. The leftover cash is called “boot” and will be taxed.  Typically, the tax will be at capital gains rates.

One of the pitfalls people fall into is failing to consider any loans outstanding on the property being sold.  If you don’t receive cash back, but your liability goes down—that, too, will be treated as income to you, just like cash.

Suppose you had a mortgage of $500,000 on the old property, but your mortgage on the new property you receive in exchange is only $450,000. You have $50,000 of gain that is also classified as “boot,” and it will be taxed.

1031s for Vacation Homes

People have asked me about using the 1031 exchange to sell one vacation home and purchase another. Some people inquire about selling a vacation home for one they may want to move into during retirement. Their intent is to do the 1031 exchange and then move into the new property, make it their primary residence, and eventually use the $500,000 Section 121 capital-gain exclusion.

In 2004, Congress tightened that loophole. Yes, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. You would need to stop using your vacation home and legitimately turn it into a rental property in order to qualify for a 1031 exchange. If you get a tenant and conduct yourself in a businesslike way, you’ve probably converted the house to an investment property. This should make your 1031 exchange work out well for you.

Per the IRS, offering the vacation property for rent without having tenants would disqualify the property for a 1031 exchange.

Moving into a 1031 Swap Residence

If you want to move into the home you just swapped for in your 1031 exchange you need to be careful.  In order to qualify for the “safe harbor” rules as set forth in 2008, you can’t move in right away.  In order to meet the “safe harbor” in each of the two 12-month periods immediately after the exchange.

  • You must rent the dwelling unit to another person for a fair rental for 14 days or more.
  • Your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

Also, after you swap one vacation home for another, you can’t immediately convert the new property to your primary home and take advantage of the $500,000 exclusion.

Before the law was changed in 2004, an investor might transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period, move into the property for a few years and then sell it, taking advantage of exclusion of gain from the sale of a principal residence. This has gone away.

Now, if you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange. In other words, you’ll have to wait a lot longer to use the primary-residence capital-gains tax break.

The Bottom Line

A 1031 exchange can be used by savvy real estate investors as a tax-deferred strategy to build wealth. There are many moving parts that if understood and properly applied, can enable you to save a lot of money on taxes while creating wealth through real estate. We recommend you seek qualified professionals to assist you in this process if you are considering it. Please feel free to contact our office for a referral. We are happy to connect you with people who are very experienced at doing 1031 exchanges.