Real estate investing can be highly profitable if done correctly. Unfortunately, there are some costs involved that are often overlooked. Capital gains tax is one of them. If you’ve owned investment property for several years, you know the pain of watching 15% to 20% of your profits taken for federal taxes. A 1031 exchange can alleviate that.
Section 1031 of the Internal Revenue Code allows real estate investors to defer capital gains taxes by reinvesting proceeds into a like-kind property. This is not an obscure tax loophole. It’s a legitimate tax planning strategy. This article explains how it can keep your money working for you, potentially saving you thousands of dollars in tax payments.
Understanding 1031 Exchanges: The Basics
Deferring capital gains taxes with a 1031 exchange is similar to reinvesting dividends in your stock portfolio. The taxes aren’t eliminated. They’re simply postponed until you eventually sell without rolling your profits into a new investment or business-use property. This helps investors maximize their returns while they build larger real estate portfolios.
This rule does not apply to your primary residence or any property you’re “flipping” or holding as inventory for development. Section 1031 requires that properties be held for investment or business use only. It also says you can only exchange for “like-kind” property, but that’s a broad definition. For instance, you can exchange an apartment building for a retail space.
It’s important to consult with your accountant before you select a new property to use in a 1031 exchange. Despite the broad interpretation allowed to describe business use properties, the IRS will deny the deduction for questionable investments. There are exceptions, but the language is subject to change each time the IRS updates its tax code.
The Financial Impact: Why Tax Deferral Matters
Federal capital gains taxes are calculated based on the income level of the investor. The tax rates range from 0% to 20%, and most investors pay 15% or higher. That doesn’t include state capital gains tax, which can increase your overall tax liability to over 25%. In Wisconsin, capital gains are taxed at ordinary income tax rates (3.5% to 7.65%).
Another concern in a real estate transaction is recaptured depreciation. The IRS taxes you 25% on the total amount you’ve claimed in depreciation over the years. That can add up quickly if you have owned the property for over ten years. If you took $100,000 in depreciation during that time, you’ll owe $25,000 of it back in the recapture.
Here’s an example: Let’s say you sell a business use property and make a $500,000 profit. Without a 1031 exchange, you could pay $100,000 in federal capital gains tax (20%), $38,250 in Wisconsin state capital gains tax (7.65%), and $25,000 in recaptured depreciation. That’s $163,250 you can either pay out or invest with a 1031 exchange.
IRS Rules and Timing Requirements
Like many IRS regulations, the 1031 exchange rule can be challenging for ordinary taxpayers. There are strict timing requirements that can disqualify you if you miss them. Our team is standing by to explain these further if you need assistance:
- 45-day identification rule: You’re required to identify up to three potential replacement properties within forty-five days of selling the original property. You can submit more than three if they meet specific value tests, but the list must be delivered in writing to a qualified intermediary. Failure to do this within the timeline disqualifies you.
- 180-day completion rule: The IRS allows you another 180 days after the identification period to complete the sale, giving you 135 days total from the beginning of the process to the end. You cannot touch the money during this period, so the proceeds from the sale must be held in trust by a qualified intermediary.
To receive the full tax deferral, your replacement property must be equal to or greater in value than the original property you sold, and you must replace any outstanding debt. For example, if you sell a $1 million property with a $400,000 mortgage, you need to exchange it for a property worth at least $1 million and take on at least $400,000 in new debt.
When 1031 Exchanges Make Sense for Your Portfolio
This tax strategy isn’t right for everyone. To start with, you need to be a real estate investor with investment or business-use properties. You’ll also need a willingness to invest again after you sell the original property. 1031 exchanges aren’t right for every situation, but they are excellent in specific scenarios. Here are a few examples of what we’re talking about:
- Upgrading to higher-value properties: This is the most common scenario where a 1031 exchange is used. An example is when you own several smaller rental properties and want to consolidate them into one larger building. A 1031 exchange helps you make that move without taking on an additional tax liability.
- Geographic diversification: Imagine that you own a property or properties in an economically depressed area. Perhaps you’d like to invest in another neighborhood where property values are on the rise. You can sell your declining properties, make a small profit, and avoid capital gains tax with a 1031 exchange.
- Moving from management-intensive to passive investments: Actively managing a multi-unit residential or business property is hard work. Older investors often take advantage of a 1031 exchange by using profits from rental properties to buy triple-net lease commercial property or professionally managed apartments.
- Building generational wealth: Estate planners use the 1031 exchange rule to build generational wealth. If the original property owners die while owning an exchanged property, the property value is stepped up to fair market value, essentially eliminating capital gains tax for the inheritor. Contact us to learn more about this.
Exchanges don’t make sense in every situation. For instance, an investor who needs liquidity can’t afford to tie their cash up in a new property. Others can’t meet the tight timeline constraints or can’t find suitable replacement properties. There are also transaction costs, including intermediary fees, legal costs, and extended holding periods.
Conclusion
There are several advantages to using a 1031 exchange when investors want to build their real estate portfolio, but it’s not the right fit for everyone. The tax deferral benefits are substantial for investors with significant gains, but the timing requirements and reinvestment obligations require careful planning. You should seek professional advice if you want to do this properly.
Before your next property sale, consult with a tax professional who understands real estate investing. We can help you analyze whether a 1031 exchange fits your specific situation or if alternative strategies better serve your goals. The wrong decision here can cost you thousands in unnecessary taxes or force you into poor investment choices.
