How to Leverage 1031 Exchange Tax code to grow your Real EstatePortfolio without paying Uncle Sam a dime?
If you have been reading my blogs, one of the corner stone as to why Real Estate is the best investment under the current tax code is the 1031 Exchange Tax Code.
1. What is a 1031 Exchange?
Here is the IRS definition:
Generally, if you exchange real property you use in your business or hold for investment solely for other business or investment real property of a like-kind, you do not recognize the gain or loss from the exchange.In English, it basically means you can immediately write off portions of certain assets in the first year you place the asset in service instead of depreciating them over many years. It is how the government uses tax codes to incentivize investment.
It is actually very simple and straightforward. There is no geological restriction as long as the real property is located in the US. There is also no property type restriction be it single family, condo, multi-family, mixed use, commercial or even land. You can exchange them all. No restrictions on the number of properties to relinquish or acquire.
The only restriction is they need to be investment property.
2. What are the requirements?
It is a great tax code, but the requirements are very strict. You really need to understand them very clearly before you conduct one to avoid walking into a time bomb.
Time – You have 45 days to identify the next property and 180 days to close.
Money – Your newly acquired properties have to be higher priced than your relinquished properties.
Ownership – There can be no difference before and after the exchange.
Intermediary – You cannot touch the funds from the closing of the relinquished properties but to leave with an escrow company.
Please make sure to consult your Tax Advisor before ever attempting this. Also, a kind reminder that most people actually have a replacement property in mind before selling the relinquished property due to this strict time line.
3. Why do people conduct 1031?
In my 30 years’ practice, I see many of my clients use this tax code creatively to grow their RE portfolio bigger and more profitable! Here are a few scenarios I can think of:
Sell appreciated properties to acquire more/bigger properties
Diversify portfolio geographically, especially to get into new exciting areas
Sell one asset class to acquire a different one due to investment strategy change
Want to exit active management role
4. Is there any reason not to do 1031?
Believe it or not, there are times this advantageous tax code will not really help you.
That is why a good tax strategy is the one that works for you, not the one everyone talks about. Here are some scenarios that you should not do exchange:
If you have massive “unused passive loss” from your other real estate activities (due to your high income), you can simply use that loss to offset your gain.
If you actually have a capital loss from selling, you should harvest this loss.
If you have a lot of other capital losses (maybe from stock investment?), you should harvest that loss against the gain from selling the properties.
5. How do I access the equity I accumulated in the property if I also exchange?
This is a very common question people have. They are worried that they will never be able to enjoy the fruits of their smart investing in Real Estate if they can never take money out because they will always have to put the funds from closing in the escrow for the next purchase.
The solution to this problem is “Cash Out” refinancing. You can access the equity on your investment property by refinancing the first mortgage and borrow more than what you owe. The remainder cash is for you to enjoy. Just be mindful not to do this Cash Out right before or after the exchange, try to time it in a different tax year.
6. For people who would like to exit active real estate management, is there any passive
This again is a common question, especially among the older generation. I have a lot of clients in my book that are nearing or at retirement age, they accumulated a lot of wealth through smart tax planning and diligent real estate investment, but they are also a bit tired of the problems brought by owning physical real property. The two best options in my opinion are:
DST (Delaware Statutory Trust) – You can own a piece of that big investment and enjoy all tax advantages deriving from owning physical real estate.
Triple Net Commercial Property – You do literally nothing but collect rent.
Sure, the returns on these two options are not stellar. But at that stage of an investors’ life, hedging for inflation is more important than capital appreciation. Risk and Reward. Just make sure it fits you. Also, these options will still generate you Tax Free cash flow. How wonderful is that! You really do not want to pay taxes when you retire!
Summary
1031 Exchange is one of the most powerful tools a Real Estate Investor can use to defer taxes on Capital Gain. If used together with Step-Up basis tax code, you never have to pay taxes on any of the capital gains from real estate investment.
But during my many years’ practice, I got a lot of push backs like:
Hard to find the replacement property
Timeline restriction so tight
Unable to use the cash from the sale
Reluctance to manage another property
From reading my blogs above, I hope you will understand that all these concerns can be addressed head on with a good Tax Planning process. Taxes erode your investment return, and in the long run, you will be so much more behind than someone who understands and utilizes the tax codes efficiently!
Justine Zhou
Justine Zhou is the CEO of Zhou Agency. She is also a senior CPA and extremely knowledgeable advisor with well-rounded expertise in tax, real estate investment and insurance services.
Justine believes in understanding clients’ needs first and providing tailored consultation to clients’ unique situation. She uses language that the audience can easily understand and is good at incorporating her expertise in both tax & real estate to help real estate investors achieve maximum tax savings.
312-808-8899
This post is to be used for informational purpose only and does not constitute legal, business, or tax advice. Each person should consult his or her own accountant, attorney, or business advisor with respect to matters referenced in this post. Zhou Agency assumes no liability for actions taken in reliance upon the information contained herein.
