If Arnold Schwarzenegger was asked to describe a 1031 Exchange, he would probably say something like, “Listen up, everyone! A 1031 exchange is like flexing your tax muscles, pumping up your investment game! So, get to the choppa, seize the opportunity, and make those exchanges work for you! Hasta la vista, capital gains taxes!” Well at least this is what ChatGPT suggested. LOL!
Benjamin Franklin is quoted with saying, “In this world, nothing can be certain, except death and taxes.” Today we will talk about how to defer taxes in real estate.
In the blog post last month, we talked about how real estate is taxed. For that post, click here. Taxes are due on the annual cash flow, long-term capital gain, depreciation recapture, and any unamortized points in the loan origination. To keep this post brief, we will focus on long-term capital gains and specifically how to defer taxes.
Let’s look at what a 1031 Exchange is, an example, the difference it can make, and some important nuances.
What is it?
Like-kind Exchanges, under the Internal Revenue Code Section 1031, is where the magic begins. When business or investment property is sold, a tax payer generally has to pay taxes on the gain at the time of sale. However, the like-kind exchange allows the tax payer to defer the takes but not get out tax free.
In some ways the like-kind exchange is the 401k of real estate. In a traditional 401k, an investor can put money into an investment pre-tax and compound interest can take over to grow the funds more rapidly, by not incurring regular taxes, over a period of time. Then when money is withdrawn from the 401k it is taxed and usable in retirement.
The key here is tax deferred.
Let’s look at a real case study. An investor bought a property in January 10th, 2012 as the real estate market hit bottom. The investor paid $101,036.10 for the investment property. The property was in really bad shape, so the investor spent $25,392.74 fixing it up to get it rent ready. This equates to a total cost of $126,428.84. This is known as the initial cost basis.
If the investor sold the property today, the property could be sold for $475,000. The costs of selling the property could be deducted from the sales price to cover real estate commissions, title insurance, other closing costs, and prorations. Let’s estimate those costs at 7% ($33,250). Therefore, the investor would net $441,750 out of the sale.
The long-term capital gains tax would be due on the difference between the initial cost basis and the net proceeds of the sale, which would be $315,321.16. The long-term capital gains tax rates are currently (2023) 0%, 15%, and 20%, depending on the investor’s ordinary income tax rate. If the investor falls into the 15% tax rate, they would have to pay $47,298.17 in long-term capital gains. Yikes!!!
If the investor opted to pay the taxes now, they would only have $268,022.99 to reinvest. However, if they deferred the taxes through a 1031 Exchange, the investor could reinvest the full $315,321.16 into a new investment.
What Difference Does This Make?
Using a financial calculator, we can estimate the impact of the two decisions over time. If the $268,022.99 was invested at 8%, compounded annually, over the next 10 years, it turns into $578,641.53. However, if the taxes were deferred and the full $315,321.16 was invested at 8%, compounded annually, over the next 10 years, it turns into $680,754.73!
By deferring the taxes, the investor could grow their investment funds by an additional $102,113.20 in 10 years! Now, imagine how much more the investor would have if the investor has 10 of these properties. The investor would have an additional $1,021,132 in 10 years simply by deferring the taxes!
The investor considering a 1031 Exchange should seek advice from a professional Realtor and a CPA. There are a lot of nuances to 1031 Exchanges and if the rules aren’t followed, the investor could end up being forced to pay the taxes. Some of the nuances to a 1031 Exchange include, but are not limited to: qualifying properties, the timeline, where the money is held, and tax reporting.
A residential investment property can be exchanged for land, an apartment building, industrial building, or other real estate. Therefore, there are a lot of different options. The investor can also purchase a Delaware Statutory Trust (DST), but that is a topic for another day. There is also a way to do a reverse 1031 Exchange where the replacement property is purchased prior to selling the original investment.
After closing on the sale of the original investment property, the investor must identify up to three replacement properties within 45 days. Then the investor must close on one of those properties in the next 135 days. The total process cannot exceed 180 days.
The proceeds of the sale must be held by a third-party intermediary. If the cash goes to the investor’s bank account, the proceeds will be taxed. If the investor doesn't reinvest the proceeds, the proceeds will be taxed.
The investor’s CPA will need to file IRS form 8824 to disclose the details of the exchange and that all of the rules were followed.
Describing a 1031 Exchange, looking at an example, the difference it can make, and some important nuances are all details in understanding section 1031 of the IRS code. A 1031 Exchange allows an investor to defer long-term capital gains. In the example, we explained how an investor would be taxed. Then we showed why deferring the taxes allows the investor’s capital to grow more over time. Lastly, we looked at some of the nuances to doing a 1031 Exchange. We could certainly spend a lot more time diving even deeper into 1031 Exchanges but this is a blog post, not a dissertation.
Contact Beacon for more information and analysis on your specific needs.
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