Investing in multifamily real estate can be profitable. However, savvy investors will know that with big profits come more taxes.
For experienced real estate investors, 1031 exchange rules offer a way to defer payment of capital gains. While this may sound too good to be true, there are clear benefits, but there are a few things to be aware of too.
Read on to learn more about 1031 exchange rules and other options to defer tax payments should they not be the right option for you.
What Are 1031 Exchange Rules?
Section 1031 of the IRC defines the 1031 exchange as when you exchange property (used for business or held as an investment) for another property (either for business or investment) that is similar or “like-kind.”
In other words, this allows a seller to take the equity that they earned (inclusive of the profit) and place it into another piece of real estate which defers the tax burden. The purpose of this allowance by the IRS is to promote re-investment in real estate as opposed to taking these earnings and investing them into the stock market or bonds, which would not be “like-kind.”
It is worth noting that this is not a wide-open window. You have 45 days from the date of the original property’s sale to identify a new property in which to reinvest your earnings and 180 days to close the deal.
Once you transfer that capital into this new property, you don’t have to pay capital gains right away, but you will once you sell the next property. It’s important to remember this as a 1031 exchange does not eliminate capital gains, it just defers it.
Pros and cons of a 1031 Exchange
There are a few things to be aware of when determining whether to try a 1031 exchange:
Pros of a 1031 exchange:
- The best-known benefit is that a 1031 exchange allows investors to use the entire amount of their equity for reinvestment in another property, potentially leading to more significant investment growth while deferring taxes.
- Investors can diversify their portfolios by exchanging one type of investment property for another. For example, you could swap a residential property for a commercial one, or vice versa.
- The exchange enables investors to relocate their investment properties geographically. For instance, if a certain market becomes less favorable, investors can move their investments to a more promising location.
- In some cases, if the property is held until the owner’s death, heirs may receive a step-up in basis, potentially eliminating capital gains taxes permanently.
Cons of a 1031 exchange:
- The 1031 exchange process is governed by strict IRS rules and tight deadlines (45-day identification period and 180-day completion period). Failure to adhere to these can disqualify the exchange.
- The exchange must be between like-kind properties, primarily meaning real estate for real estate, which can limit options.
- Since all of the equity must be reinvested in a like-kind property, investors cannot cash out any part of the sale proceeds without incurring taxes.
- Finding a suitable replacement property within the 45-day window can be challenging, and investors might feel pressured to settle for a less-than-ideal property.
- There are costs associated with a 1031 exchange, such as fees for the Qualified Intermediary, and potentially higher costs if rushed decisions lead to suboptimal investments.
- It’s crucial to remember that the taxes are deferred, not forgiven. Capital gains taxes will eventually be due if the property is sold without another 1031 exchange.
How to do a 1031 Exchange
A 1031 Exchange is not for novice investors as there are many steps involved. To perform a 1031 exchange you need to:
- Identify the Property to be Sold: This is the property you currently own and want to exchange. It must be an investment or business property, not a personal residence.
- Set Up the Exchange: Before selling your property, you need to set up the exchange by contacting a Qualified Intermediary (QI). The QI holds the proceeds from the sale of your property and uses them to purchase the new property. It’s crucial to involve a QI before the property is sold to ensure the exchange is valid.
- Sell Your Property: Once the property is sold, the proceeds go directly to the QI, not to you. This is to comply with the rules of the 1031 exchange that disallow you from taking possession of the money.
- Identify Replacement Property: Within 45 days of the sale of your property, you must identify up to three potential replacement properties of equal or greater value. This identification needs to be in writing and delivered to the QI.
- Complete the Purchase of Replacement Property: You have up to 180 days after the sale of your original property (or until the tax return due date, whichever is earlier) to close on one of the replacement properties. The QI will use the proceeds from the sale of your original property to purchase the replacement property.
- Report the Exchange to the IRS: When you file your taxes for the year, you will need to report the 1031 exchange on IRS Form 8824, detailing the properties involved in the exchange.
One other method that may be easier is to participate in a DST (Delaware Statutory Trust). This is where multiple 1031 investors pool their money into the trust, and the trust represents 100% of the equity in the new deal. While it is often a bit simpler than the 1031 process, that does not make it “easy.”
There is an alternative to a 1031 exchange that offers similar benefits to investors looking to reduce their tax burden after a property sale.
A simpler alternative to a 1031 (with similar benefits)
Instead of attempting a 1031 exchange, you can take the proceeds from a sale and invest in a deal with a real estate syndicator.
Investing alongside an experienced sponsor allows you to put your wealth into a quality property and reap the tax benefits that come with accelerated depreciation, reducing the capital gains you will have to pay.
You’ll get similar tax benefits as with a 1031 exchange, minus the hassle of managing a deal and the paperwork with the IRS by yourself. Investing in a multifamily deal provides many of the upsides without the downsides that can come with a 1031 exchange.
Learn more about the tax benefits of investing in real estate
Learn more about the tax benefits of investing in multifamily real estate with our free guide. In this guide, you will learn how multifamily real estate can help you reduce your tax burden, diversify your wealth, and hedge against market risk.
Download the Tax Benefits to Multifamily Real Estate Guide
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