When you sell investment property or other types of real estate and you have a capital gain, you usually need to pay tax on the gain at the time you close the sale. IRC Section 1031 allows an exception that let’s you postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Capital gains deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
What you’ll be learning here is how a 1031 exchange can be used to grow your real estate wealth.
1031 Exchanges are the Midas Touch in real estate. Once you understand the rules to a 1031 exchange how to use them to grow your investment portfolio, you’ll be able to keep on moving up the pay grade. While a bit complicated at first glance, we’ll soon have you on your way to building your wealth through real estate whether you’re in your twenties or nineties.
Whether you end up doing a 1031 exchange or not make sure you understand the tax deductions when selling a house. There are so many people who never make the appropriate tax claims they are afforded. Not taking deductions is like throwing money out the window!
How to Begin
Diving into your first property is always the scariest. Truly it is. You may not be entirely sure about this whole real estate investment thing, and you are probably crossing your fingers and praying it doesn’t turn out like your Great Aunt Mary who invested her life savings into a venture only to find out the man skipped town with her money.
In order to make it out there in investing, you’ve got to be willing to take risks, and this is your first step in the right direction.
You could begin with any investment property, really. It could be a single-family home in the middle of North Carolina or an eight-unit apartment building in California. It could even be buying your first home that you decide to turn into a rental. It just needs to be an investment property that you either plan on renting out or using for business purposes (not including holding property to build a house on and sell).
As you rent it out, notice the statistics on your investment property. How is the cash flow? Are there many repairs needed? If so, what is the profit after the repairs are completed? How easy is it for you to rent out? How frequently are you able to raise your rent? These are all excellent numbers to keep track of to help you see the pros and cons of this particular property. Knowing these numbers will also help you identify more profitable properties for your next venture.
Once you have your investment property (or two or three), you can begin to build.
How to Build
Decide Which Property to Exchange
Now comes the fun part. Once you have some real estate investment experience under your belt and it’s time to move onto properties that are a bit less hands-on and generate more of an income, you can start thinking about your 1031 exchange. Identify properties that you want to sell and exchange for other investments. Maybe the numbers don’t quite do it for you, or the maintenance is just getting to be a bit much.
You should know the reason why you want to exchange and be able to point to your spreadsheet to support it. There is no point in getting into investing if you are not willing to track your numbers. That leads to guessing about numbers and could even get you to foreclosure. You can’t move up if you don’t know what is “up” for you.
Identify The New Property or Properties
Once you’ve identified the property you are going to use in the exchange, you are ready to rock and roll. Don’t list your property for sale yet, though. Most investors recommend finding the property or properties that you want to exchange your property for before you list your property for sale.
When using a full 1031 exchange, make sure that 1) the total purchase price of the properties you are exchanging are more than– or equal to– the sale price of the property you are selling. And 2) The total purchase price for the properties you are exchanging does not exceed 200% of the sale price of the property you are selling.
Remember: part of the freedom of the 1031 exchange is that you are not limited to buying low-income rental units if that is what you get in on. You can take a single family home and exchange it for an apartment building. You can take an apartment building and trade it for a commercial property. You are not limited to properties similar to the one you are selling.
Sell Your Home
Once you’ve got an idea of the properties you want to purchase, you’ll want to list your property for sale. Make sure you use a real estate agent that has worked with 1031 exchanges before because there are some exceptional circumstances that they’ll need to be aware of.
Once you get an offer on your property, you’ll need to identify an intermediary to hold the money from the sale in escrow. Since you are not allowed to touch the money when it is in escrow, you will need a trusted 3rd party to keep it for you. Some intermediaries work solely with those doing 1031 exchanges and charge a small fee. Your real estate agent should be able to point you in the right direction of one.
From the close of your property, you have 45 days to identify the properties you are wanting to exchange with. By 180 days after the close of sale on your property, you need to close on the new properties. This time period goes by quickly, which is why we recommend locating your properties before selling your first home or property.
Where do I go from there?
The great news about 1031 exchanges is that you can do them as many times as you want. You’ll want to hold onto your properties for at least a year– two if you’re going to be completely safe– before exchanging them. Keep in mind that you can swap one property for up to three every time without paying taxes, so there really is no reason to cash out. Especially if you are making good money on renting out those properties.
A Few More Tips
In a perfect world, you won’t need to ever sell your properties. But what if you hit a bump in the road that requires you to have cash on hand? Should you sell one of your properties and just pay the tax? You could do that.
Or you could take out a Home Equity Line of Credit (HELOC) from one of your properties and use that money tax-free. There really are not very many reasons that you’ll need to sell your properties.
If you want to get out from all the hard work involved with finding tenants and such, you could go in on a significant commercial property with a bunch of investors. They usually have someone else managing tenants and repairs, and you are just the financial backer.
If you want to have something to pass down as an inheritance, put your properties in the will! The way it’s set up, those you pass your portfolio to will be able to cash out on the properties while paying a minimal amount of tax.
1031 exchanges really are a fantastic way to build your wealth in real estate. As always, though, be aware that we are not your accountant and are in no way providing financial or legal advice. Talk to your accountant and real estate agent today to begin building your wealth and achieving your real estate goals.
About the author: Andrew Schmeerbauch is an avid real estate investor and the Content Director at Clever Real Estate, a real estate startup offering flat fee commissions for home sellers. Visit the Clever Real Estate Blog to find all the latest information for home buyers and sellers.