How to Lower Your Taxes with 1031 Exchanges

As a real estate investor, you wear many hats: marketer, negotiator, manager, designer, accountant… sometimes even a construction crew member. You squeeze every penny and every dime out of the project. You work for months, getting up early, working on weekends and holidays, and taking all sorts of calls after hours. Not only you don’t get paid, but also spend a wazoo of your own money with the hope that one day you will make a profit. And when that day comes, guess who is knocking on your door? It’s Uncle Sam, and he wants his share. This is why every rehabber owes it to themselves and their families to know how to reduce their taxes. Reducing taxes directly increases the net return on investment. By keeping more of the income generated from their properties, investors can achieve a higher ROI, making their investments more profitable. One of the best ways to do this is a 1031 exchange.

What is a 1031 Exchange?

A 1031 exchange, also known as a like-kind exchange or Starker exchange, is a tax-deferral strategy used by real estate investors. It allows investors to defer paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into a similar (like-kind) property.

The primary benefit of a 1031 exchange is the ability to defer capital gains taxes that would otherwise be due upon the sale of an investment property. Under normal circumstances, if you hold your investment property for less than a year, your profits are treated as ordinary income and are taxed at your marginal tax rate. Depending on your total taxable income, these rates range from 10% to 37% for individuals. A 1031 exchange allows you to defer tax payments by reinvesting all the proceeds from the sale of the property into another investment property.

What are the 1031 Exchange Requirements?

Understanding and navigating the rules of a 1031 exchange can be complex, but here are some basic rules to remember.

Property Requirements

Like-Kind Property: Both the property you are selling and the replacement property must be like-kind. For real estate, this broadly means any property held for investment or productive use in a trade or business. Examples include residential, commercial, and industrial properties, as well as vacant lands and farmlands. Primary residences or vacationn homes are typically ineligible for 1031 exchanges (with the exception of some loopholes).

Equal or Greater Value: To fully defer capital gains taxes, the replacement property must be of equal or greater value than the relinquished property. Additionally, all proceeds from the sale must be reinvested in the replacement property.

You can also reinvest the proceeds into multiple properties. Things get more complicated here, but in general the number of replacement properties is limited to three and their collective value cannot exceed 200% of the relinquished property value.

Title and Ownership: The same taxpayer who sold the relinquished property must be the one to acquire the replacement property. This ensures continuity of ownership for tax purposes. That means you cannot own a property in the name of an LLC and then to 1031-exchange it to a property held in your personal name.

Timeline Requirements

In addition to property being “like-kind,” the 1031 exchange process must adhere to the strict timeline requirements.

45-Day Identification Period: After selling your investment property, you have 45 days to identify a potential replacement property. Bear in mind that you don’t need to have this property under contract in order to “identify” it. But what you must do is to deliver a written notice identifying the property (or properties) to your qualified intermediary.

180-Day Exchange Period: You have 180 days from the sale of your investment property to complete the purchase of the identified replacement property.

Qualified Intermediate Requirements

To properly execute a 1031 exchange, you must hire a qualified intermediate who will ensure compliance with the rules and will maintain proper documentation. This qualified intermediate will also hold your sale proceeds in the special escrow until the 1031 exchange is completed. At no point can any portion of the proceeds be transferred to you. It’s not difficult to find a qualified intermediary. Many title and escrow companies offer such services.

How Real Estate Investors Can Position Themselves for a Successful 1031 Exchange?

Getting positioned for a successful 1031 exchange involves careful planning and also some luck.

Give yourself time to identify a replacement property: Since you only have 45 days to identify a new property after the sale of your original investment property, you need to start looking well in advance. In my experience as a hard money lender in the Maryland and DC area, it might take three or more months to find a deal with a decent profit margin. You have to start looking while the renovation process of your original property is still underway to allow yourself ample time.

Choose the title company you want to use as a qualified intermediary: Ask them about their track record in the facilitation of 1031 exchanges. Make sure they are available to answer your questions and guide you through the documentation requirements both when selling your original investment property and buying a new one. In addition, review their fees and ensure they are both competitive and transparent.

Secure Financing and Funding: As we learned, you have 180 days to acquire the identified property to comply with the 1031 exchange rules. In reality, few sellers will wait that long. That means that you need to work with a private lender that is fast and flexible. If you are financing your new property with a hard money loan, your offer is equivalent to cash. Your lender will likely not require a home inspection, and the appraisal will be based on the after-repair value of that property. This straightforward process removes contingencies that can delay or prevent the settlement. Many hard money lenders are familiar with the process and, together with the title companies, will offer support and guidance.

New Funding Resources is also well familiar with the process. We’ve been involved in numerous 1031 exchange transactions and built our own investment portfolio using it. However, we are not the ultimate experts. For the details, contact your title attorney or your accountant. Together, we can help you manage your risk and build long-term wealth in real estate.