Hello fellow real estate investors,
Some of you are well versed with the term “1031 exchange” and others may have very little knowledge on the process. In this article, I will begin by defining what 1031 exchange is. Then explain some of the basic requirements and procedures for using a 1031 exchange. Finally, I will walk you through a hypothetical example to highlight the major tax advantages of utilizing a 1031 exchange to build and maintain wealth in real estate. If you ever have more in-depth questions about the process, please reach out to our team and we can provide more information and put you in touch with the right experts. *I am personally not a cpa, all the numbers included are simplified and estimated*

According to Inestopedia.com: “Broadly stated, a 1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another. Although most swaps are taxable as sales, if yours meets the requirements of 1031, you'll either have no tax or limited tax due at the time of the exchange. In effect, you can change the form of your investment without (as the IRS sees it) cashing out or recognizing a capital gain. That allows your investment to continue to grow tax 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. Although you may have a profit on each swap, you avoid tax until you sell for cash many years later. Then you'll hopefully pay only one tax, and that at a long-term capital gain rate (currently 15% or 20%, depending on income – and 0% for some lower income taxpayers).”

In order to properly and legally execute a 1031 exchange, there is a set of rules that needs to be followed. The biggest limitation is that the 1031 can only be used on investment property and the property you are selling needs to be “like-kind” compared to the property you are purchasing. This does not mean the properties need to be exactly the same. The rules are broad in the sense that you can exchange many types of property so long as they are all held as investments. For example, appreciated land can be exchanged for a 4-plex, a single family house for a duplex, an apartment building for a single family house, even multiple properties into a larger property, so long as the properties are all held as investments and the rest of the rules are followed.

Another limitation is the timing of your sale and purchase. In general, once you sell the first property, you have a total of 45 days to identify the replacement property and a total of 180 days to close on the sale. There is an alternative to this called a “reverse 1031 exchange” that can be utilized in special cases to close on the replacement property first and then sell the exchange property. This is more costly and is further complicated if there are loans involved in the transactions. Also, if your equity investment in the replacement property is less than the proceeds from the sale, that remaining amount would be considered taxable income. So if you are downsizing into a cheaper property or using a lot of leverage, you may not be able to defer all of the taxes due.

In the following example, we are going to learn about Joe Investor and his potential to maximize his long term returns utilizing the 1031 exchange. Joe is a 40 year old investor and he owns a 4-plex that he bought as an investment for 200K back in 1998. At the time, the land was valued at 40K and the building at 160K. Joe has depreciated the building on a 27 ½ year schedule, resulting in a nice depreciation tax benefit of $5,800 annually (160K/27.5). Over the 20 year period he has owned this property, he has taken a total of $116,000 in depreciation expense ($5,800 x 20). This has lowered his taxable income and saved him money on his taxes each year he has owned the property.

Now it is 2018, Joe is 60 years old and his building is even older. He is getting to the point where he wants to sell his 4-plex and purchase a newer investment property. Joe heard from the locals down at the tackle box that home values were up BIG! Joe is excited and calls upon the expertise of the Moving Chico Team to see what his property is worth. At first he is surprised to hear that his property he bought for 200K cash is now worth 600K, which is more than double what he paid for it twenty years prior. Joe was looking at a 400K capital gain!

Joe initially pictures himself walking away with close to 400K in profit. First though, we need to get Joe hooked up with a CPA to look at his tax situation. Joe is employed in sales and will retire in a few years. He is making good money and is in a 15% federal and 10% CA state tax brackets. The capital gain of $400K on his property would result in 2018 federal capital gains of 15% for a total of $60K. Joe lives in California, so add on an additional 10% or $40K in CA state taxes for a total of $100K in capital gains taxes. Then Joe needs to pay back those depreciation tax benefits he took. This process is called depreciation recapture. Joe will have to recapture the depreciation at a federal rate of 25%. In this case, that equates to $116K x 25% = $29K. So Joe is looking at only actually netting 270K of his 400K gain. Once Joe informed the Moving Chico Team that he also wanted to BUY another property, Joe was referred by the agents to a 1031 exchange provider to go over his options.

At the meeting, he was excited to learn that he could sell his property and reinvest the proceeds without having to pay any of the above $130K in taxes. Rather, he could use a 1031 exchange to defer those taxes by transferring them to the new property. In this case, Joe is now able to reinvest his entire 400K gain into the new property, which gives him an additional $130K of purchasing power. This is what makes the 1031 exchange process so favorable, especially for longer term investments. To take this example one step further, Joe has two sons that he plans to leave the property to when he passes away. When that happens, his sons will receive “Stepped-Up” basis to the fair market value of the property on the date of their father’s death and effectively they will be shielded from any capital gains that have accumulated on the property. In addition, the accumulated depreciation recapture will also be wiped out when the property is transferred to his sons. This is by and large one of the most beneficial strategies to grow and pass on financial wealth in a tax advantaged manner. If you are curious if this may be a good option for you, please reach out and we will further educate you on the process and put you in touch with the experts.

*Please take note that I am not a CPA or a 1031 exchange expert. You should take care to do your own due diligence and reach out to the proper experts for further research given that each person’s situation will be different and the tax laws are very complex*