Welcome back! This week we’re going to continue the real estate talk and address a slightly more complicated section of the tax code – section 1031. Like all other sections of the tax code, 3-4 living people have actually read it. Lucky for you, I am one of them and am here to explain it to you like you’re a 3rd grader.
What is it?
Section 1031 of the tax code involves exchanges of like-kind property as a way of deferring capital gains taxes. Here’s what that means. Let’s say I have a rental property that I’ve owned for a number of years. You might remember from last week (you don’t) that I’ve taken depreciation on the property and have some built-in gains. I purchased it for $100,000 and have taken $20,000 in depreciation, so my net cost basis is $80,000 for tax purposes. I’m ready to get rid of the property, and the market value is $150,000. If I just sell it, I’m going to have a $70,000 gain for tax purposes ($150,000 – $80,000), which would really stink.
However, I’m thinking of just reinvesting the proceeds into a new investment property anyway. Section 1031 says that if I do this properly, I can defer the $70,000 in gains that I have built in. For example, if I sell the property and then purchase a new like-kind property for $150,000, I can essentially kick the $70,000 gain down the road and roll it into my new property. For tax purposes, instead of saying that I paid $150,000 for my new property, I’ll instead say that I paid $80,000 for it, which was my tax basis in the old property. That will ensure that if I sell this new property, I will end up paying tax on the gain from my original property that I’ve deferred. I’ve essentially increased the amount that I have invested in real estate by cashing out gains from a prior purchase, but I didn’t have to take a tax hit from the gain on the sale because I’m purchasing something substantially similar. I can reinvest the full amount of my proceeds into something new and defer those taxes. If I purchase something for less money than the $150,000 I receive, I’ll likely have to pay a small amount of tax on the difference between the two prices.
The rules and misconceptions
In order to get this special tax treatment and deferral of tax implications, you do have to follow the rules. First off, the properties involved have to be “similar.” The definition of similar is surprisingly loose in this section of the tax code. I can swap a house for an apartment building and still qualify. I can even just swap for land in some circumstances. However, it’s important that both properties are investment/business properties. One of the most common misconceptions with this that you can sell your vacation home and just buy a new one without paying tax. However, if it’s not being rented out, it’s generally not a qualifying property. Another misconception is the need to use this section of the tax law in order to avoid capital gains on the sale of your primary residence. Sales of residences are covered under a different kind of gain exclusion. If you’ve lived in your house for 2 out of the last 5 years, you can already exclude up to $250,000 in gains if you’re single, and $500,000 if you’re married. There is no need to swap for another property to avoid paying capital gains taxes in this situation.
An important concept is the need to involve a qualified intermediary to facilitate this transaction. You cannot just sell one property, purchase another one, and declare that you’ve done a 1031 exchange. It’s the equivalent to Michael Scott declaring bankruptcy in The Office. Instead, you have to hire an intermediary that holds the proceeds from the sale of the first property, then purchases the new property for you. Once the transaction is finished, they’ll distribute any proceeds remaining to you. If you touch the money at any point before this is finished, your transaction may not qualify.
In order to qualify for the tax deferral, you must identify your replacement property within 45 days of the closing of the original property. You have to do this in writing (usually to your intermediary). If you’re not sure which property to pick, you can identify up to 3 properties in writing within 45 days. As long as you close on one of them within 180 days, you should still qualify. The 180 day timeline is an important one in a competitive real estate market, so it’s a good idea to have things lined up as soon as you possibly can.
Why do it?
Although it sounds like a pain, 1031 exchanges can have big payoffs. With some smaller properties with smaller amounts of gains, it may not make a ton of sense to go through the trouble. However, for larger properties, these tax deferrals can be a really important planning technique. Not only does it allow you to build a larger real estate portfolio, but it can also defer taxes permanently if you die holding the property. If you die and pass on a property with deferred gains from 1031 exchanges, your heirs generally get a step-up in basis on that property before they liquidate it. That means their tax basis in the property is the fair market value of the property on your date of death.
This technique works great with the estate tax planning technique of “buy, borrow, die.” Imagine I purchase a property for $100,000. 30 years from now, I’ve traded properties in 1031 exchanges, and the property I hold now is worth $1,000,000. I haven’t paid any taxes on my gains. I’ve also been able to borrow against this $1,000,000 property to pay my living expenses. Since borrowing is not taxable, I was basically able to use my tax-deferred income without paying tax on it. Then, when I die (of heart disease statistically), my heirs inherit the property without having to pay income taxes on those gains. That’s why there are years when Elon Musk and other rich folks hardly pay any income taxes. They have an asset (their stock in public companies) that they simply borrow against. They’re not selling the stock, so they’re not recognizing any of the gains. They’re just leveraging the value of their assets, which isn’t taxable income. I’m very anti-debt in general, but this is a pretty great strategy if executed properly