The 1031 Exchange (pronounced “ten thirty-one”) gets its name from its inclusion in Section 1031 of the IRS tax code. By exchanging one like-kind property for another, you can defer capital gains taxes until you die.
When to 1031 Exchange?
It would be much simpler to tell you when NOT to 1031 Exchange.
1. If you have owned and lived in the subject property as your main home for 2 of the past 5 years you do not need to 1031. Per the IRS tax code, you can already exclude $250,000 in capital gains or $500,000 if you file jointly.
2. Sorry flippers! While there is no set time you have to own a property in the tax code, the IRS considers flips “held for resale” and therefore they do not qualify. Your property must be an investment and to show that, per the experts, it should be held for at least one year. You don’t want to risk the IRS determining your 1031 Exchange did not qualify and now you owe thousands of dollars you might not still have.
What qualifies as like-kind?
Well, it’s vague.
The IRS says, “Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”
Cool. How does this make me RICH?
The following numbers and time frames closely mirror one of my very first investments.
Say you have $30k to invest. You purchase a rental for 150k rent it out for 3 years and sell for 250k or a 100k profit. Most of you will be in the 15% long-term capital gains tax bracket so without 1031’ing you really walk away with 85k.
Now, lets continue as if we perpetually 1031 every 3 years for 12 years total with the same 3.3 equity multiple as we had in deal one and assuming 20% down on each property. After 12 years and 4 deals later we now have $3,593,700. If you paid 15% capital gains on every sale you would be left with $1,875,934.
That is almost double the money by deferring taxes with a 1031 Exchange. I’ll leave you with that to reflect on.
As always, we want to hear from you! Join the discussion and tell us your experience with a 1031 exchange. Has it ever not made sense for you for reasons we didn’t include? Tells us about the challenges associated with identifying your replacement property.
Is there another way to defer the profit from the sale of real estate? YES!!
Want a more detailed 1031 example? Check out: