Many people have made impressive profits from investing in real estate. Yet whenever you make money doing something, you can expect the Internal Revenue Service to be around, looking for its share of your gains.
Fortunately, there are ways that you can use the rules governing real estate taxation to your advantage. If you want to sell a business or investment property that's gone up in value and your transaction qualifies for favorable treatment as a 1031 exchange, then you can put off having to pay taxes on your gains indefinitely. Below, we'll look more closely at the rules governing 1031 exchanges.
1. You can exchange different kinds of real estate...
The rules governing 1031 exchanges say that trading real estate for "another property of like kind" lets you avoid having to take any taxable gain as a result of the transaction. In the past, the IRS interpreted that rule pretty strictly, requiring real estate investors to trade only real estate that was very similar in nature and use.
Over time, however, interpretations of the tax law have gotten more lenient, and you can therefore use 1031 exchanges for a much wider variety of property transactions that in the past. For instance, you can trade vacant land for developed properties, office buildings for multi-family residential properties, or shopping centers for self-storage facilities.
2. ...but you can't go international
Tax regulators are still strict about one aspect of 1031 exchanges. In order to qualify for favorable tax treatment, you can't trade a U.S. property for a foreign property, or vice versa. In other words, if you have international real estate, you have to trade it for another piece of real estate located beyond U.S. borders. If you have domestic real estate, you'll need to find another piece of property inside the U.S. to exchange for it.
3. 1031 exchanges don't have to be direct
At first glance, it might seem like nobody would ever do a 1031 exchange, because it would be so difficult to make it work. Taken literally, doing an exchange would require finding someone who both owns a piece of property that you want and who wants your specific property in return. Especially if you're considering a different type of real estate or a property in a much different location than the one you currently own, it could be next to impossible to find an owner willing to do a direct exchange.
Fortunately, the 1031 exchange rules allow for what's known as a qualified intermediary. This allows you to use this third-party entity to facilitate two separate transactions, one in which you sell your existing property and the other in which you purchase the replacement property. The buyer of your current property doesn't have to be the same as the seller of the replacement property you purchase, dramatically expanding the pool of available candidates.
4. You have to finish 1031 exchanges in a short timeframe
It used to be that the timeline for completing a 1031 exchange was essentially unlimited. However, some changes to the tax laws established a stricter timeframe to get deals done. There are now two deadlines you have to consider with a 1031 exchange.
First, if you use a qualified intermediary to sell your existing property, then you have to identify the replacement property that you'll buy with the proceeds with 45 days of the sale. If you miss that deadline, then you'll have to pay taxes on the capital gain from the initial sale.
Once you identify the replacement property, you then have some additional time to complete the purchase. The closing on the replacement property purchase has to occur within 180 days of the original sale -- that is, 135 days after the 45-day deadline on identifying the replacement property.
5. You can do a 1031 exchange in reverse
The problem with the regular 1031 exchange is that you have to sell your initial property before you buy a replacement. However, the rules also allow for what are known as reverse 1031 exchanges. What's reversed in a reverse 1031 exchange is the order in which you do the transactions.
Instead of selling the existing property first, a reverse 1031 exchange has you buy the replacement property first. Then, you have 45 days to identify the existing property that you intend to sell, and a total of 180 days after the purchase to close on the sale of your existing property. Again, if you meet all those requirements in time, then you'll avoid having to take any capital gains on the property that you sold.
6. You can't use 1031 exchanges on your house
In order to qualify for favorable tax treatment, the real estate you use in a 1031 exchange has to be "held for productive use in a trade or business or for investment." That means that you can take a personal residence or other real estate that you use for strictly personal purposes and exchange it for another type of real estate without paying taxes on any gains.
That requirement applies in both directions. Therefore, you can't take a business property and exchange it for a property you intend to use as a personal residence or for other personal purposes. Both properties must be available for business or investment use to get beneficial tax treatment.
7. Cash you receive in an exchange is usually taxable
Often, there's a difference in the value of the properties that are part of a 1031 exchange. If you exchange your property for a more valuable property and pay extra cash to the seller, then there aren't any adverse tax consequences for you.
However, if you make an exchange for a less valuable property and you're the one who gets some cash, then that money is subject to tax as capital gain. In many cases, the cash you receive will be less than the total gain on the property. You won't pay tax on more than the money you actually received as part of the exchange transaction.
8. Changes in your outstanding property loan balance can also be taxable
Many real estate investors obtain financing to purchase their properties, and the 1031 exchange rules pay close attention to what happens to outstanding property debt as part of these transactions. As long as the amount of debt you assume on the new property is at least as much as your previous debt on your existing property, then you'll be fine.
However, if your loan balance on the replacement property is less than what you owed on the old property, then you'll have tax consequences. The IRS treats you the same way as if you had gotten actual cash as part of the exchange. So if your outstanding loan went from $150,000 to $125,000 after the exchange, you could be looking at $25,000 in extra income as part of the deal.
9. You'll sometimes give up depreciation on a 1031 exchange
One key tax benefit of owning real estate is depreciation, and when a buyer obtains a new property, getting to take depreciation on the full purchase price can produce valuable immediate tax deductions. However, with a 1031 exchange, avoiding capital gains tax comes at a cost: the tax basis on which your future deduction gets calculated remains the same as it was with your old property.
For example, say you had a $1 million property that doubled in value and you exchange it for another property worth $2 million. If you had simply bought the $2 million property outright, your depreciation would be based on the full $2 million amount. However, in the exchange, you'll calculate your depreciation based on the original $1 million amount for the original property -- less any depreciation you've already taken on that old property in the past.
Know what you're doing
1031 exchanges can be a great way to cut your taxes, but you can't afford to get blindsided by the rules. By thoroughly understanding how 1031 exchanges work, you'll be able to use them to maximum advantage in managing your real estate investment portfolio.
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