5 facts you must know about 1031 tax deferred exchange
I have received numerous calls in the last month about investors doing a 1031 tax deferred exchange. In fact the last 6 months have generated more inquiries about 1031 exchanges than in the past 6 years.
The 1031 tax deferred exchange has always been popular; however, since the real estate decline that started close to a decade ago there has obviously been less need for the 1031 Tax deferred exchange. This was in large part because selling a property in un-certain times was scary to do. The truth be told (and hind sight being 20/20) this would have been an incredible time to sell smaller properties and trade up to bigger properties.
During a buyers’ market sellers may have not had much profit to report on the sale of their smaller properties. They would have however had great buying power in a buyers’ market on the more expensive higher priced property giving them massive leverage and buying power..
Upgrading to better property with declining values obviously had no merit, so timing the rebound of the buyers’ market was paramount. Now with the real estate market running full steam ahead and value of properties going upward, the benefit of a 1031 exchange is becoming a very popular tool once again.
New investors especially want to know what exactly this tool is, and why everyone is talking about it now. I have always stated that all these blog post are derived from repeated questions to a topic so I know you investors are interested in knowing more.
1) What is a 1031 Tax Deferred Exchange?
As many savvy investors will share with you, a 1031 Exchange is a vehicle that allows you to sell an investment and defer the capital gains taxes. Simply stated, it allows you to roll over the capital gains (which you would ordinarily pay taxes on) into the next investment. As a simple example if you bought a property for $200k and sold it for $300k you would have $100k in profit this $100k is subject to taxes. (Now this is where Tax advisors write in and tell us they can find you some deduction within here to lower this taxable rate down) but I am aiming to keep examples simple.
The 1031 in this example takes this $100k of taxable income and as long as you buy another investment property and follow the IRS guidelines they will essential roll these tax liabilities into your new property allowing you to defer paying taxes on the gains.
Needless to say, there are rules and restrictions around how you must do this, but when done correctly allows you to build up a great amount of equity growth and continue to trade up to bigger and better investments. Many investors keep trading up and keep deferring until their death and then as they Will the properties to their next of Kin the capital gains taxes are essential passed away. See 1031 rules and guidelines at Internal revenue code section 1031.
2) Why is everyone talking about it now?
I can appreciate why this questions has arisen as you have not heard much about 1031 exchanges in the past few years. As you understand and internalize what a 1031 exchange is used for, the reason for it being quiet lately and now earning more attention will make sense.
Investors tend to sell their investments when they can get top dollar for them and then they like to reposition that asset into the next great deal or the next emerging market.
Since the real estate market bottomed out and prices have since rebounde, it once again makes sense to trade up to better performing assets or perhaps a different asset class.
Now that prices have been rising and they are able to sell their earlier purchased properties for a nice gain, the need to defer the taxes on that gain has once again surfaced.
3) What are seasoned investors trading up to?
Emerging markets: Markets within the country are positioned differently. Some are at the beginning stage of a buyer's’ market while others are becoming sellers markets. As markets climb in one part of the country toward a seller's’ market, there are other parts of the country that are just beginning their growth stage (the buyer’s market). It makes great sense to sell their higher priced properties that have already realized a gain and now approaching a seller's’ market and reposition into the next growth (buyer’s market).
Trading into different investment classes: Some people who currently own single family homes, are trading into larger multi-family homes and vice versa. The number one choice by tenants lately has been to rent a single family home, Therefore, we now are seeing people selling their duplexes, triplexes and fourplexes and investing in these highly sought after single family houses. The nice thing about 1031 exchanges is there are no real restrictions on how much the investment costs as long as you spend equal to or better than the amount of the exchange. For example if you sell a $200,000 duplex and buy 2, $100,000 single family houses you are good, you just want to be sure you spend all $200,000 to realize the full deferment.
4) Variety of investments
Recently the Tax codes have been re-written and the 1031 exchange has stayed pretty much intact. For a while you use to be able to exchange many investment vehicles. I have heard of people who invest in horse racing and their horses were being exchanged. The trade had to be considered a LIKE KIND exchange, but was not limited to real estate. I believe some of these exchanges have been eliminated but as real estate investors we have come out of the new 1031 tax reform revisions in good shape.
. The key thing to remember is to follow the rules as written. There are no exceptions to the rules, but following them have the ability to save you thousands in tax deferment.
5) Trade up and escalate your investment portfolio
If you have owned an investment for a period of time and have a hunch that there may be better investments available for your investment dollar, I strongly encourage you to look into the viability of doing an exchange and accelerate your investments forward.
We are happy to discuss this with you. If you would like to see what may work best for you we are happy to offer complimentary strategy calls.
We are not tax professionals or attorneys. Therefore opinions on HowToBuyUSARealEstate.com should not be confused for legal or tax advice. Please seek licensed professionals for such purpose.