I absolutely love how much I learn every day in real estate. This week I took a class on 1031 Exchanges and y’all probably think learning about the tax code is super boring, but I was on the edge of my seat! Because 1031 Exchanges are one of the best tools a real estate investor has for escaping taxes.
And, fun fact: it’s been around since 1921. Seriously. (I could really nerd out on the history because it has to do with enacting capital gains taxes for the first time because of World War 1 and then people freaking out about it, and thus a tax-avoidance plan was worked out.)
So here’s the deal: If you own rental property or several properties, or are planning on becoming a real estate investor, you should be very familiar with what a 1031 Exchange is and how to use it to save money on taxes.
Here’s how an exchange works:
Let’s say you bought a single- family home in 2010 and have been renting it out. But now you’d like to sell it in order to buy another rental property, or even several rental properties. The investor in this scenario would simply put their rental home on the market, then when it sells, have a firm that specializes in these exchanges hold the money they made off the sale of that property. Within 45 days, the investor must have identified at least three properties he or she is interested in purchasing that are of equal or greater value than the relinquished property. And within 180 days, the investor must have closed on one or several of those identified properties.
If an investor follows those rules to a T, then no taxes are owed on the profit from the relinquished property or properties.
Here’s the interesting thing: these exchanged properties don’t have to be very similar. Basically so long as it’s real estate, it counts as an exchange. So an investor could sell land and buy a house, or sell a condo and buy a ranch. You can even exchange residential for commercial or vice versa.
The only downside to doing an exchange is that it forces an investor to make a decision what to buy for their next property very quickly. You have 45 days from the closing of your relinquished property to find your next investment. Most 1031 firms charge very nominal fees for their service, such as a $1,000 flat fee for each transaction, so if you aren’t able to find a property in time, the worst that happens is you lose $1,000 and then you have to pay the taxes you were trying to avoid.
So who might benefit from a 1031 Exchange? Obviously any investor who is planning on buying or selling investment properties on a regular basis.
Another type of investor who should think about doing an exchange is anyone who has owned rental property for a long time in a rapidly appreciating part of town, in Austin I’m thinking of neighborhoods like Crestview, East Austin and North Loop. Why? Because of your value is in the land and there is only so much rent you can charge for that 1,000 square-foot bungalow from 1950. By selling that home and purchasing, let’s say, two rental homes in a different part of town, you are able to increase the amount of rental income you generate every month while still not paying any additional taxes.
A few things to know about doing 1031 Exchanges:
- You have to have this set up before you close on the sale of your relinquished property. The fee to the exchange company for holding your money is paid essentially as part of your closing costs.
- If you identify, let’s say, four properties you are interested in purchasing on Day 40, but then change your mind on Day 60 and want to buy a different property, it won’t count as part of a 1031 Exchange.
- To lengthen that 45-day window, you can always start shopping for your next property the minute you go under contract for your relinquished property. The 45-day clock only starts after you close.
- You cannot do a 1031 Exchange on a property you have lived in, or intend to live in. This is for investors only. The only little loophole is that you could sell an investment property, use a 1031 Exchange to buy a home that you then have to rent for two years. After that, you can live in it!
I am certainly not a CPA or 1031 Exchange adviser, so for specific questions about exchanges, please seek the advice of a tax professional or 1031 Exchange firm. I can recommend several of these firms here in Austin if you’re thinking of going this route.
Lilly Rockwell is a licensed real estate agent in Austin, TX and a former journalist. She can be reached at firstname.lastname@example.org or 512.413.1975.