Legal Matters & Taxes How to Leverage the 1031 Exchange to Grow Your Wealth by Kate Supino September 17, 2019April 14, 2020 by Kate Supino September 17, 2019April 14, 2020 If you’re a real estate investor and you aren’t taking advantage of the 1031 exchange, you’re missing out on a valuable wealth-building opportunity. It’s widely said that the biggest advantage of the 1031 exchange is being able to defer capital gains tax. And while that is certainly a huge benefit, it’s not the biggest. The biggest benefit is the chance to grow a real estate portfolio worth millions of dollars with a comparatively small initial investment. What Is the 1031 Exchange? The 1031 exchange references a section of the Internal Revenue Code. Although it may be new to you or your accountant, the 1031 exchange rule was created back in 1954 as an amendment of Section 112(b)(1) of the tax code. The details have been altered over the years, but the essential spirit of the law has remained. Essentially, the 1031 exchange allows for the tax-deferred exchange of like-kind property under certain circumstances. As recently as 2017, Section 1031 property categories included assets like collectible art, securities, franchises, and more. However, with the passing into law of the Tax Cuts and Jobs Act of 2017, as of December 22, 2017, the only property category allowable under Section 1031 is real estate. The Basics of the 1031 Exchange Rules As a new or seasoned real estate investor, you know that real estate takes many forms. For the purposes of Section 1031, qualifying real estate is that which is “held for productive use in a trade or business or for investment.” Non-qualifying real estate is “real property held primarily for sale.” Specifically, fix and flip projects are not allowed under the 1031 exchange rules. As far as the property types, nearly all types are allowed: single-family homes duplexes, triplexes, etc. townhomes apartment buildings warehouses distribution centers factories raw land commercial buildings (retail, office, etc.) Like-Kind Requirement A real estate investor can exchange any investment property for like-kind property and avoid the capital gains tax on the sale of that first property. The IRS says, “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.” There’s no limit on the number of like-kind 1031 exchanges that can be done in a lifetime, and there’s no cap on the capital gains tax that’s deferred. Best of all, the investor can defer the capital gains tax forever. The investor can legally avoid paying capital gains tax on any of the real estate sales on their property ladder in perpetuity. Time Restrictions Several time restrictions are placed on the investor who wants to take advantage of the 1031 exchange. The first important time restriction is that when you sell a property, you must identify the next property or properties you wish to invest in within 45 days of the first property’s closing date. This rule allows you to formally identify up to three properties. The second major time requirement of Section 1031 is that you must take possession of the exchanged property within 180 days of the first property’s closing date, or “the due date (determined with regard to extension) for the transferor’s return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.” Regarding these time restrictions, it’s important to note that the day count is actual days and not business days. So essentially, you have just over a month and a half to identify your next property and about six months to close on the new property. To find the best investment properties in your city and neighborhood of choice in just 15 minutes, click here. Savvy real estate investors already know that finding good deals is challenging. If you have a family and a full-time job, that 45-day restriction makes it very tough to comply with the 1031 rules. For that reason, many 1031 exchange investors rely on turnkey rental company inventory, where they can very quickly find cash flowing deals that meet the investment property criteria. Investors can then formally identify that property or properties in accordance with 1031 exchange rules. Working with a turnkey rental company for 1031 exchanges is also safer, since ordinary sellers may inadvertently cause delays that jeopardize the 180-day closing rule. When you buy from a turnkey rental company that owns all their listings, you know you’re dealing with a professional seller accustomed to real estate investment deals. Keep Title in the Same Name The titles to all the properties you buy and sell as 1031 exchange must all be titled with the same taxpayer’s name. This is to be taken very literally, too. You can’t purchase your first property under your personal taxpayer name and then buy your exchange property under your new business name. You can’t add your spouse to the title names, either. Doing any of these things will likely disqualify you from being able to claim the transaction as a 1031 exchange. There may be other nuances of Section 1031 that you need to be aware of. You should consult with a CPA to ensure you’re following every rule down to the last detail. Leveraging the 1031 Exchange to Grow Your Wealth One way that clever real estate investors leverage the 1031 exchange rules is as a wealth-building strategy. The ability to defer capital gains tax on unlimited property sales – even through the end of your life – enables you to methodically build wealth for yourself and to pass on that wealth to your heirs. Here’s how it could work for you: You start out with just $17,000 to invest. You don’t have the time or inclination to do a rehab, so you decide to start by buying a nice turnkey rental property in an affordable real estate market, which cash flows from day one. A few years later, your property has appreciated in value. Before you put it up for sale, you formally identify another property that you plan to purchase. You sell property A and make a nice profit. You use the profit from that sale plus your original $17,000 and use it for a down payment on a bigger and better property. You don’t pay capital gains tax because you’ve complied with the rule of Section 1031. Down the road, property B is worth substantially more, so you sell it and turn another profit. You take that profit and add your original $17k to that and buy an even better property. You can continue this scenario over and over again without ever paying a penny in capital gains tax. After several years, you could potentially own a real estate investment portfolio of millions of dollars. And remember, this isn’t even counting the cash flow that you earn from each of those properties throughout the years. Another benefit of this strategy is that you get to pass along your portfolio to your heirs. When they inherit and sell your property, they may pay very little or even no tax! Their taxes are calculated on a stepped-up cost basis equal to the current fair market value because they aren’t realizing any gains. This is a win-win strategy for both you and your heirs. If you decide to move forward with the 1031 exchange strategy, it’s crucial that you work with a qualified intermediary and a tax professional. Otherwise, you could easily fail one of the many qualifications and end up paying capital gains tax. Also, please note that I am not a tax professional and this is not intended to be investing or tax advice. The purpose of this content is informational only. This article has been contributed by Kate Supino. Start Your Investment Property Search! START FREE TRIAL 1031 ExchangeGuest Blogs 0 FacebookTwitterGoogle +PinterestLinkedin Kate Supino Kate Supino is the Marketing Strategist at RealBizTools.com, a marketing and writing services company for real estate professionals and investors. Previous Post 22 Real Estate Social Media Marketing Ideas for Agents Next Post Scottsdale Real Estate Market 2020: Should You Invest Here? Related Posts Should Real Estate Investors Set Up an LLC for Rental Property Investments? 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