Investing in real estate offers significant tax advantages. For instance, investment property owners can depreciate a portion of their purchase costs, reducing taxable income without an associated cash outlay. But, a failure to plan for the tax consequences of a sale can lead to enormous capital gains and depreciation recapture bills to the IRS. Fortunately, strategies like the 1031 like-kind exchange exist to defer these tax bills when you sell an investment property. As such, we’ll use this article to answer the question: how does a 1031 exchange work?
Specifically, we’ll cover the following topics:
- What is a 1031 Exchange?
- How Does a 1031 Exchange Work?
- Final Thoughts
What is a 1031 Exchange?
Overview
Normally, when you sell an investment property for more than you purchased it, you must pay a capital gains tax. For instance, say you purchased an apartment building for $1,000,000 then sold it several years later for $1,500,000. In this situation, you’d have a capital gain of $500,000 (ignoring transaction costs). Depending on your income bracket, this would be taxed at a rate of 0%, 15% or 20%.
Additionally, the IRS allows owners of investment properties to depreciate that property over a set period of time (27.5 years for residential and 39 years for commercial real estate). While this lowers taxable income while holding the property, the IRS claws this benefit back when you sell a property through a process known as depreciation recapture. Continuing the above example, say you claimed $100,000 in depreciation expense while operating the property. At sale, the IRS would impose a depreciation recapture tax at a flat rate of 25%, translating to an extra $25,000 in taxes.
Clearly, selling an investment property can lead to a significant tax bill. Fortunately, the IRS offers investors a way to defer (i.e. delay) paying these taxes. Section 1031 of the Internal Revenue Code allows for a like-kind exchange – commonly referred to as a 1031 exchange. This 1031 exchange lets investors sell an investment property and roll the 1) gains, and 2) accumulated depreciation into a new property, deferring taxes in the process. In other words, when you execute a 1031 exchange, you don’t need to pay capital gains and depreciation recapture at that time.
Recognizing Gains from “Boot”
Before pursuing a 1031 exchange, investors should also understand the concept of “boot.” When you fail to roll all of your proceeds from the sale of a property into the purchase of the new one, you are said to have received boot. Say, for example, you receive $500,000 cash in the sale of a property. If you keep $100,000 of that and reinvest $400,000, that $100,000 would qualify as boot, and you’d need to pay capital gains tax on it.
Additionally, investors must recognize boot when their new mortgage is smaller than the old one. For instance, say you have a $250,000 mortgage when you sell the old property. Then, you purchase the new property with a $200,000 mortgage. In this situation, you would have $50,000 in mortgage reduction boot, which would require capital gains tax.
How Does a 1031 Exchange Work?
Executing a 1031 exchange requires strict compliance to IRS rules and shouldn’t be attempted without professional tax advice. With that said, here are the primary steps to a 1031 exchange:
Step 1: Identify the Property You Plan to Sell
Before exchanging property, you first need to identify what you want to sell. As part of identifying the property you plan on selling, items to consider include your taxable basis, current mortgage, and market value.
Step 2: Retain a Qualified Intermediary
IRS rules mandate that you don’t actually handle the 1031 exchange yourself. Rather, a 1031 exchange accommodator – or qualified intermediary – sells the property, receives the sales proceeds, holds those proceeds in escrow, then executes the purchase of the new property on your behalf.
Qualified intermediaries should be experienced in all aspects of a 1031 exchange. Failure to strictly adhere to all Section 1031 rules can result in the recognition of capital gains. As such, investors should thoroughly vet potential qualified intermediaries to ensure they have a track record of successful 1031 exchanges.
Step 3: Sell the Property
Once you identify the qualified intermediary, you will sign a contract with him or her to execute the 1031 exchange on your behalf. In this capacity, intermediaries will sell your property, collect the proceeds, and hold them in an escrow account.
Step 4: Identify Replacement Properties within 45 Days of Sale
Beginning on the settlement date of your sale, you have 45 days to identify up to three potential replacement properties to purchase with your sales proceeds. This 45-day period, known as the “identification period,” requires that you send detailed descriptions of the potential properties to your qualified intermediary.
Of note, you don’t need to purchase all of these properties – just one. But, by allowing you to identify three potential properties, the IRS provides flexibility in case your desired property falls off the market before you can purchase it.
Step 5: Close on the New Property within 180 Days of Sale
Within 180 days of selling the old property, you need to close on the purchase of the replacement property. Due to inevitable delays in the closing process, you’ll want to provide yourself a buffer to ensure you don’t miss this important deadline. That is, don’t schedule your closing on Day 179, as a delay would likely lead to you needing to recognize capital gains on your sale.
Step 6: File IRS Form 8824 and Recognize Taxable Gain on Boot, As Required
To report a 1031 exchange to the IRS, you need to file Form 8824, Like-Kind Exchange. This form reports your sale and deferred gains, and you must file it in the tax year of the sale of the original property.
As part of this filing, you’ll also need to recognize any taxable gain on boot received, if any. As outlined above, if you receive cash or a mortgage reduction, you are said to have received boot and must pay the associated capital gains tax.
Final Thoughts
While owning an investment property offers outstanding tax advantages, new investors also need to plan for the sale of those properties. Fortunately, a variety of tax strategies exist – like 1031 exchanges – to help you at tax time.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associated tax implications.