I have been considering various options for my real estate investments.
My preference would be to buy more rental units, but both markets I’d consider (where my current places are in Grand Rapids, Michigan or my current city of Colorado Springs) are waaaaaaay over-priced IMO. And I’m more of a value buyer when it comes to real estate.
I could just call it quits and sell it all since my places have appreciated nicely (probably much more than when I received this estimate). But that would kill me on taxes and I’d lose a major source of income, so what’s the benefit of that?
An option in the middle is that I could trade properties — cashing in all my places (or some of them) for bigger and better real estate. I could do this using a 1031 exchange. The problem: I don’t know much about 1031 exchanges.
So I contacted my friend, Michael, from Your Money Geek, and asked him to cover the subject. He’s a financial planner with experience using 1031 exchanges.
In addition, ESI Money readers are familiar with his writing. He’s penned the following:
- Are Solar Panels Worth It?
- How to Make Money with a Hobby Farm: The Unsung Super Hero Of Side Hustles
- Top Ten Money Mistakes People with Modest Incomes Make
- Why Taking Social Security Early Might Be the Best Option (He wrote an extensive section here, not the whole post)
As such, he was the perfect choice to write this piece!
So with that said, I’ll turn it over to Michael to tell you all about 1031 exchanges…
Successful real estate investors often exercise the use of the 1031 exchange. The 1031 exchange is a tax strategy that allows the investor to save on capital gains taxes from the sale of a property.
It’s estimated that in 2020 the use of the 1031 exchange will become more prevalent because of the spike in real estate prices across the country. If you’re a real estate investor or you’re interested in becoming one, understanding the benefits of the 1031 exchange may help you maximize your profits. Read on to discover the ins and outs of what a 1031 exchange entails and what you should consider before you use one.
A Certain Point of View
“You’re going to find that many of the truths we cling to depend greatly on our own point of view.” – Obi-Wan
Tax planning is one of the most difficult aspects of financial planning. It is bad enough that the tax laws are constantly evolving and that they were written in a way that five “experts” can read the same regulation and have 6 different interpretations of what they mean.
However, that’s not even the worst part.
The challenge in tax planning is that it’s not purely economic or mathematic. When engaging in tax planning we must make some assumptions about the future, such as where do you think tax rates are heading, are they going to higher or lower in the future?
Additionally, we must consider your specific goals:
- Are you planning of leaving all your assets to your children?
- Are you leaving everything going to charity?
- Do you need more income?
- Do you have more income than you can reasonably spend?
- Or do you require some combination of the above?
The best tax plan for you may likely depend on your point of view and goals. So, I always caution readers to do your homework and talk to qualified professionals about your options.
The purpose of this post is to give you a quick primer on 1031 exchanges and introduce you to a few alternatives.
What is a 1031 Exchange?
Under section 1031 of the IRS code, the term 1031 exchange is addressed. Essentially, the 1031 exchange allows investors to defer paying capital gains taxes on an investment property when it’s sold. However, the proceeds must go toward the purchase of another like-kind investment property.
This strategy doesn’t only help limit your tax liability, it also allows real estate investors to shift their investing focus while not incurring taxes.
Let’s say that you are currently investing in a high-maintenance property that requires a lot of your time and energy. If you decide your profit isn’t worth your time, you may want to sell the high-maintenance property and purchase a low-maintenance property.
Another example would be if you want to buy a property in a different state. You may be able to do so by selling one and using this strategy.
Since it’s highly unlikely that the person you want to buy a property from wants your property as well, you will need a middleman to assist with the transaction.
This middleman will act as a third-party who will hold the proceeds of the sale while the other transaction is underway. This third-party exchange is treated as a swap.
When You Should Consider a 1031 Exchange
When you sell an investment property, you are responsible for paying the capital gains tax. Even if this purchase turned out to be a poor investment, you may end up owing more than you made. This is where the 1031 exchange comes in.
If you have a property that’s worth more today than it was when you first bought it, this strategy can help you maximize your profits. So, to engage in an exchange you will have to find a like-kind property that’s the same value or greater value than your current property.
While you may cash out when it’s all said and done, this strategy can help you prolong your taxation.
Types of Real Estate Exchanges
There are different types of exchanges. The most common exchanges are simultaneous, reverse, delayed, and improvement exchange.
Here’s a breakdown of what you can expect from each exchange.
A delayed exchange is where an investor sells a property before they purchase a new one. Essentially, the owner of the property (Exchangor) transfers the property first and then exchanges it when the second property is purchased. The delayed is probably one of the most common forms of exchange.
With this type of exchange, the owner is responsible for advertising the property, finding a buyer, establishing the sale and purchase agreement prior to initiating the exchange. After the process initiates, the owner or Exchangor must hire a third-party to hold the funds during the exchange of properties.
The Exchangor has 45 days to identify a property and 180 days to execute the exchange. The reason this type of exchange is so popular is that it gives the owner of the property more time to find a replacement.
A simultaneous exchange is where the sale and replacement of property complete on the same day. Both properties must close on the same day for this type of exchange to occur. If there are any delays such as the timeframe for the money to be wired over, the exchange may be disqualified. This would then result in full taxes applied to the transaction.
This type of exchange can occur by a swap or two-party trade, three-party exchange, or simultaneous exchange with a qualified middleman and who facilitates the entire transaction.
Construction or Improvement Exchange
With a construction or improvement exchange, the taxpayer can use the exchange dollars to make updates to the replacement property. They can proceed with renovations while the property is in the hands of a middleman.
They have a 180-day period to complete the construction or improvements to the property.
A reverse exchange or otherwise known as a forward exchange, occurs when the property owner finds a replacement property before they sell their own. The property owner will purchase the replacement property through accommodations offered by a titleholder.
What makes this exchange a little more complex is that you have to use cash for the purchase of the replacement property. Additionally, many banks or financial institutions may not offer loans on this type of exchange. So, unless you have cash for the purchase, you may be out of luck.
Also, you must close on your prior property within 180 days to ensure you can use this type of exchange. If you do not close within 180 days, you may have to pay the full tax amount.
When you conduct a 1031 exchange, like-kind properties must be close to the same value. The difference in the value from the property you sold versus the property you replaced it with is called boot. If your replacement property is less value than the property sold, the cash difference is taxable.
This also goes for the mortgage value. If the mortgage is permissible on either side of the transaction, the difference may be treated like a boot. This is an important consideration when calculating your 1031 exchange.
Additionally, fees and expenses due to the transaction can cause a boot as well. However, there are some exceptions. These expenses can be paid with the exchange funds. Some of these fees and expenses include:
- Filing fees
- Broker’s commission
- Tiles insurance premiums
- Finder fees
- Escrow fees
- Intermediary fees that qualify
Some expenses that may not qualify include financing fees, property taxes, maintenance costs, and insurance premiums.
1031 Exchange Alternatives
Instead of using a 1031 exchange, here are some other options you may want to consider…
Paying the Tax Now
Ok, so this option may sound like pretty lame tame tax planning, however, it’s worth considering. Today long-term capital gains rates are 15% for those in the 25%, 28%, 33%, and 35% ordinary-income brackets, and just 20% for those in the 39.6% bracket.
From 1954 to 2003 maximum long-term capital gains ranged from 21% to 39.87%. The low rates we are experiencing today are historically unprecedented, which begs the question, will taxes go up in the future???
A 1031 exchange essentially defers the tax, it doesn’t eliminate it. At some point, Uncle Sam and his nephews State and Local will be looking for their cut of your profits. Some thought should be given to whether they should be paid off at today’s low rates or some unknown and potentially higher rates in the future.
I’ll Beat the IRS by Dying!!!
In my 20 years of financial planning and working with clients exchanging property, I have heard this plan numerous times. If you aren’t familiar with this tactic, here how it works.
You defer paying capital gains taxes on your real estate via exchanges, then when you die, under current law the beneficiaries receive a “step-up in basis”
For example, Bob has a rental property that he bought at auction for 1 dollar ten years ago. It’s currently valued at 1 million dollars. So, if Bob sold his property, he would owe taxes on $999,999.00. (Ouch) Instead of selling the property and paying the tax, he decides to die, leaving the property to his 3 children.
Under current law, Bob’s children would receive a “step-up in basis” meaning that the children’s cost basis in the property was the valuation of the property on Bob’s death, i.e. 1 million dollars. Should Bob’s children sell the property immediately to purchase a new Corvette, the IRS would treat the property like they paid 1 million dollars for it. Assuming they sold it for 1 million, they would owe no capital gains taxes. (Pretty sweet right?)
If they hold on to the property for some time before selling, they would just pay capital gains on the growth, if any, above 1 million.
What Could Go Wrong?
If you were a politician, who would you rather tax; the living or the dead?
The dead, of course, since dead people don’t vote, and they don’t complain. In fact, death taxes (Inheritance taxes) have historically been much higher than income taxes. In PA inheritance taxes can be as high as 15% — that’s nearly 3 times the rate of our income taxes.
Eliminating the step-up of basis has been a political chopping block for some time. Potentially, nothing will ever come of it, or it could be gone tomorrow.
I have 4 rules regarding financial planning:
- Don’t over-complicate things.
- If it sounds like a Simpsons episode don’t do it.
- Don’t assume the government won’t make things worse.
- Don’t rely on planning that only works if you’re dead.
Beating the IRS via death violates rules three and four and possibly two.
Selling your property via an installment sale allows you to spread the tax liability over the course of the agreement.
For example, if Bob from above decided to sell his property rather than die, he could finance the transaction for the new seller and receive payments instead of a lump sum. This would potentially allow him to spread his tax liability over the term of the installment agreement.
The benefits of an installment agreement are being able to spread the taxable gain over the term of the contract. So, if Bob decides to finance the property for the new owner for 10 years, the tax liability would be spread out over then years.
Additionally, Bob would likely receive some interest in exchange for offering owner financing and may make more money than by trying to sell the property and reinventing the lump sum.
What Could Go Wrong?
Owner financing is not without risks since the new owner could default on the note. In that case, you would need to foreclose on the property. Additionally, if you find the wrong buyer collecting payments can be a nightmare.
I lent my neighbor money, secured against their land, years ago. I don’t believe we ever received one payment on time, they always had some sad story on why they were late. Given my experience, it’s not something I would do again.
However, I have had a few clients offer seller financing and they collected massive down payments, only to then later foreclose on the property. They then were able to turn around and resell the property at a massive profit.
If you are going to attempt this tactic, make sure you secure a large down payment and ensure that the buyers have good credit.
Deferred Sales Trust
A deferred sale trust is kind of like selling on an installment but without the default risk. With a Deferred Sales Trust (DST), you sell your property outright, however instead of receiving a lump sum, the funds go to an intermediary (Trust) that then pays you on an installment.
The DST eliminates the risk of the borrower defaulting on the loan; however, it adds the cost and complexity of hiring a lawyer and CPA firm to handle all the paperwork and act as an intermediary.
To some extent it violates my first rule, don’t over-complicate things, however, the tax savings can be substantial. This is especially viable in situations where you want to reduce taxes, but do not want to purchase a like-kind property or additional property.
Charitable Remainder Trust
A Charitable Remainder Trust (CRT) is an excellent option for people with deferred capital gains who wish to leave some of their assets to charity.
With a CRT you may transfer highly appreciated assets to the trust, and the trust is then able to sell those assets without paying capital gains taxes. The trust then can pay the grantor income for as long as they are alive. When the grantor passes, whatever is left in the trust (remainder) goes to the charity or charities of the grantor’s choice.
Let’s say our friend Bob decides he needs some additional income and he wants his money going to the church when he passes. He could transfer his property to a CRT and avoid the capital gains tax on selling. The CRT would then invest the money (stocks, bonds, annuities, etc.) and pay Bob’s income for the rest of his life.
When Bob dies, whatever is left in the CRT would go to the church. The only real downside is that the funds in the CRT would not be available to his family.
However, if Bob wanted money to go to his family, he could leave them other assets, or even use a portion of the income from his CRT to purchase life insurance.
This one might be a little bit of stretch because it’s not really eliminating or deferring the tax bill, rather it is transforming it into something productive.
Currently, the IRS is providing a 30% tax credit (27% in 2020) for installing solar. In addition, business owners and investors can potentially depreciate the cost of a solar installation. The combination of depreciation and tax credits means that the government could potentially reduce the cost of your solar project 70% or more.
As an example, let’s say I own a commercial building, and I wish to exchange it for a new commercial building. Instead of doing a 1031 and deferring the tax, I could sell my first building outright triggering a taxable event. Then purchase the second commercial building and install a large enough solar arrange to wipe out my tax liability from the first sale.
The advantage to this approach is I added value to the second property, reduced energy costs that may improve cash flow, potentially created a great PR opportunity for my business, and preserved my ability to depreciate the new building helping to offset income taxes.
Depending on the state and utility incentives available it’s possible this approach could pay you back your money in four to six years, and even potentially generate passive income or an equity-like return in the long run.
The Bottom Line
While using a 1031 exchange is a great strategy to maximize your real estate profits and minimize your tax burden, there are still some rules and regulations you will need to follow.
For a detailed outline of the rules and regulations of the 1031 exchange visit IRS.gov.
While I hope the above gives you some ideas as to what might be possible, when dealing with substantial taxes it’s best to enlist the help of a qualified pro.