REI Tax Hack: 1031 Exchange
Save Hundreds of Thousands 💵
Let’s say you bought a rental property in 2020; you’re ready to sell and make a tidy 200K profit. But at a 35% tax rate, you owe the IRS a big, fat $70K. Ouch! Now, you don’t want to pay the IRS $70k. At the same time, you don’t want to go to prison for tax evasion. Fortunately, there’s another option: the 1031 Exchange.
A 1031 Exchange, also known as a “like-kind exchange”, is a tax-deferral under Section 1031 of the IRS code. It allows you (as an individual or a business) to sell an investment property and then defer any capital gains tax owed on the profit of the sale IF you reinvest those capital gains into another investment property.
As long as you close on your next property within 180 days of selling the previous one, you can use that chunk of change you owe Uncle Sam to buy a new investment!
‘Til Death 💀
The IRS’s position is, “No worries, pal: We’ll catch you when you sell that property.” But, if you just do another 1031 exchange when you resell, and then another, continuing to reinvest, pushing out the payment until you die… you win! Your heirs won’t pay taxes on all those glorious gains you accrued during your lifetime, because of a neat little tax twist called Step-Up in Basis.
It’s 1031s all the way down!
But if you want to turn your capital gains tax into funds via 1031 exchange, know this… 📙
1. This is only for rental property investments. Flippers can’t use it. Why, because property that is “held primarily for sale” doesn’t qualify for 1031. The code is specific that the properties being held are for “trade” (such as a place of business) or “investment”(such as a rental), and not for resale. To check on that, IRS will look at duration of ownership, reason for buying, etc.
2. The asset must be held for a minimum of two years—a period known as “qualifying use.” Within each 12-month period, you must rent the property out for a minimum of 14 days at fair market value. And you cannot live in the property yourself for more than 14 days of each year.
3. Timing can feel pretty tight. After selling property A, you get just 45 days to identify your next property (you can hone it down to three), and then 180 days to close on it. The 45 days can be stressful: If you’re in that 45-day search window, be sure to use the Backflip app to run the numbers on as many options as possible swiftly. Even if you can’t find the right property in time, all is not lost: Consult a tax professional about a Delaware Trust or a 721 exchange.
4. Follow tax law carefully. For instance, you have to declare intent to do a 1031 exchange before selling the property. And when the property is sold, the proceeds must be held by a qualified intermediary: It’s crucial not to take direct possession of the sale proceeds.
5. If you do decide to cash out in your own lifetime, you will have to pay those accrued taxes. Still, to fuel your investments, it’s smarter to have cash to play with now than to give it away.
You may have noticed the 1031 exchange isn’t one to try to pull off alone, so consult with a tax professional on the 1031 Exchange—and come back for more REI tax hacks!
Disclaimer: This article is for informational purposes only and is not legal, financial or investment advice. To obtain advice tailored to your particular circumstances, you should consult a licensed professional advisor.