What Is A 1031 Exchange? How Does It Work?

If you’re a real estate investor, the 1031 exchange—which gets its name from Section 1031 of the U.S. Internal Revenue Code—is your best friend! Why? Because for about 100 years, the 1031 exchange has allowed real estate investors the chance to reinvest the profits from the sale of a property without having to pay capital gains tax. As long as you replace one investment property with another and follow all the rules set by Uncle Sam (we’ll get to all of those in a minute), you can keep kicking that tax bill down the road.

What is a 1031 Exchange?

In essence, the 1031 exchange gives investors the opportunity to move property they had purchased within a certain time frame and realize substantial capital gains tax benefits. With a personal 1031 exchange, you create a “Trust” or “Subscription”. In order for the Trust to exist, you must contribute your property to the Trust. When you make an exchange, the property must remain in the Trust. When you sell your property, the proceeds must be disbursed to the Trust. Once your property is used to fund the Trust, any income that is generated by the property is reinvested into the Trust in the form of a distribution (or dividend).

How does 1031 Exchange work?

To understand the 1031 exchange, we need to take a quick break and dig into some confusing tax law jargon. We promise the confusion ends here. It’s actually very simple. A tax break is called a “sell-through” because the original investment property has been sold. The profit from that sale can then be reinvested into another real estate investment. But the selling property can’t be sold at the same time that it’s bought. For example, say you are looking to sell your first investment property, a duplex in California, for $300,000. If you purchase a new investment property, say a 2-bedroom, 1-bathroom apartment in Maryland, for $200,000, and then sell that one in California for $300,000, you would only be taxed on $300,000.

Benefits of a 1031 Exchange?

Keep reading and we’ll go over some of the major benefits of a 1031 exchange! Keep in mind, while the benefits below are geared towards real estate investors, you should follow these rules if you’re trying to sell any other type of investment property. If you sell your property in a 1031 exchange, the proceeds you receive will be taxed as ordinary income by Uncle Sam. While this is all good news, it can also be confusing. Luckily, we’re here to help! The way the IRS determines your gains on a property sold in a 1031 exchange is pretty simple. The IRS will look at what you sold your property for, along with any other income you may receive on that property—whether it’s your salary or rental income.

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Choosing a Replacement Property for a 1031 Exchange

The first rule of a 1031 exchange is that you have to start with the property you plan to invest in and sell. You’re not just exchanging the property for cash; you’re also making a down payment on a new investment. This new property must be located in the same state as the one you sold, and you’ll also need to close on that property before the end of the year. At this point, you’ll need to figure out exactly which investment property you plan to replace. Start with your finances, and find a piece of real estate property that you’re willing to buy from a seller in a transaction known as a “1031 exchange”. The catch is that you’ll need to have a property to sell. If you don’t have one, then you’ll need to rent one out until you do.

What Is Depreciation and Why Is It Important to a 1031 Exchange?

If you take a look at the IRS guidelines for Section 1031, you’ll find that the two main factors that go into deciding whether you can use the 1031 Exchange to your advantage are depreciation and an increase in value. When you own a rental property, you’re losing a chunk of your earnings each year to property taxes. And let’s face it, when you’re in the market for a new home, you’re not going to want to shell out hundreds of thousands of dollars more on property taxes. Since depreciation on your home is going to take a long time (that’s the point!) and housing prices are always going to rise, if you own a rental property, then you’ll have to lose a lot of money before you can begin to come out ahead.

1031 and Estate Planning

Before we get into the details of 1031, it’s important to address two important issues: 1) What does 1031 mean for real estate investors? 2) What is a 1031 exchange supposed to do? 1031 means that the 10% of capital gains tax that an investor pays on the sale of one property can be reinvested in another property. This is a tax deferral. Let’s say that an investor sells their house and redeems their appreciated stock in an S corporation for $150,000. With $150,000 in capital gains, the investor still has to pay $4,400 in capital gains tax. But if instead, the investor had reinvested $150,000 in the market, without paying capital gains tax, then the investor would receive a $6,600 gain in market value. That’s a $4,400 difference. One is taxed; the other is not.

1031 Exchange Expertise

Not all investors know about the 1031 exchange, or they don’t know how to use it to their advantage. Fortunately, our friends at Rand Realty, Realty One Group, and Freeman Real Estate have mastered the art of the 1031 exchange—so you don’t have to! Realty One Group’s Mike Brenner learned about the 1031 exchange in the 1980s while selling multifamily properties in Brooklyn and Manhattan. Today, he’s a consultant to the real estate industry, with knowledge of the 1031 exchange that stretches back more than 25 years. Brenner says the easiest way to create an income stream and turn a profit on a property you sold is to buy another property with the funds you’d usually use to purchase that initial property.

How much do you need to spend and borrow for a new 1031 exchange property?

If you are a big-time investor—and you should be, because you are going to enjoy the most tax advantages—the cost and time of your 1031 exchange will depend on the amount of money you have invested in real estate and the size of the proceeds from the sale of your current property. It is not unusual to spend $50,000 to $100,000 on a new property, but if you are doing a 1031 exchange, the cost will probably be less because you are getting some money back. When you come up with your list of what to buy, you have two options: One is to buy what you like and “unwrap” it and decide where to move it next, or you can buy some sort of a “placeholder”—one that you really like but aren’t sure how you’re going to use it in the next year.

Calculating the cost basis of the property you sell

The tax code is clear when it comes to how you determine your cost basis. You’ll need to use the year you bought the property, the acquisition date, and the period you owned it (within a year and a day). If you’re thinking about selling your property for more than you paid for it, it’s important to do some research. While there are exceptions, a sale for more than your purchase price is considered a short-term gain (i.e., less than one year). A sale for more than two years of ownership is considered a long-term gain (i.e., more than two years). It’s also important to remember that as long as you don’t live in the property, or rent it out, there’s no gain to be had when you sell the property.

Conclusion

Overall, the amount of money available in the real estate market at any given time and the number of properties available to purchase are a relatively small part of the reason the mortgage market has been so much stronger during the past few months. If the same logic applies to the housing market as it does to the mortgage market, then the surging prices won’t mean much because there won’t be nearly as many properties to purchase. In order to fix this, the economy needs to continue to improve. That will force people to spend money on more goods and services, which will push prices back up. In the meantime, however, the signs of life in the real estate market are undeniable.

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NB: The purpose of this website is to provide a general understanding of personal finance, basic financial concepts, and information. It’s not intended to advise on tax, insurance, investment, or any product and service. Since each of us has our own unique situation, you should have all the appropriate information to understand and make the right decision to fit with your needs and your financial goals. I hope that you will succeed in building your financial future.