Real estate investments come with a lot of great benefits. Some of those benefits are tax advantages. As a rental property owner, you can deduct a lot of the expenses associated with your rental property, including maintenance and mortgage interest, insurance and property management fees, and you can even use depreciation to lower your overall tax liability.
While the benefits are outstanding, there can also be tax penalties when you’re ready to sell a real estate asset.
As you probably know, when you buy a property and hold onto it for some period of time, and you’ve earned profits from it and taken depreciation credits, but there will be a reckoning when you decide to sell that home. You’ll have to pay capital gains taxes on the profits you earned on the investment. And, you’ll also have a depreciation recapture to manage.
This is a lot of money cutting into your ROI, and it can be a substantial drain on your motivation to sell. It really disincentivizes a lot of people from selling their real estate.
Luckily, a 1031 option is available to real estate investors like you and most investors find that it’s a valuable tool when it comes to protecting their income from capital gains and other taxes.
What is a 1031 Exchange Program?
The 1031 Exchange is named for the IRS tax code to which it pertains. According to this rule, an investor who has made a profit from a real estate investment or taken depreciation tax credits can defer the tax on both if they purchase another property of equal or greater value. It has to be a property of like kind, and there are specific time limits that are attached to this exchange.
This is an incredibly effective tool for many real estate investors, especially when they’re trying to leverage their rental properties. If you find yourself wanting to sell but resisting the urge because you don’t want to incur those tax burdens, this program might be exactly what you need. It allows you to unlock the equity and the profits that you have in your current property and move that money into other properties with more growth potential or diverse investment benefits.
Some terms you need to understand are:
- The property you want to sell is called the relinquished property.
- The property you decide to buy is called the replacement property.
You’ll want to understand the program and its rules completely before you venture into this process. We also recommend that you work with an expert broker or property manager who specializes in 1031 exchanges and the work that’s required to make the effective.
Deadlines and Restrictions Associated with 1031 Exchanges
Let’s say you have a rental property that you want to sell. You don’t want to recapture the depreciation that you claimed on your taxes and you don’t want to pay capital gains taxes. So, you decide you’re going to sell the property through a 1031 exchange and save yourself some money.
First, you’ll probably sell your rental home, making it a relinquished property. Once the sale closes on that deal, the escrow company is going to move the proceeds from that sale into a qualified intermediary’s exchange account.
You need a qualified intermediary in order to successfully complete the 1031 exchange.
The intermediary holds the profits you earned from the sale of the relinquished property.
Now, you have 45 days from the sale of your relinquished property to identify the replacement property.
You are also required to close on the replacement property within 180 days of closing on the relinquished property sale.
This timeline might seem relatively easy to follow. With 45 days to identify a property and 180 days to close on that property, you probably feel like you have plenty of breathing room. But, time is of the essence and we recommend you work as quickly as possible to complete this exchange. The longer you wait, the more time you have for complications to arise.
The other restriction is that you’re required to buy a property that’s of equal or greater value. So, if you sold a duplex for $1 million, you are required to buy another rental property for at least $1 million. Or, you can buy several properties as long as they equal $1 million or more.
It’s also necessary to exchange one rental for another rental. You cannot use the 1031 exchange to sell a rental home and then buy a piece of land that isn’t attached to income. You cannot sell your rental home and then use the 1031 exchange to buy yourself a vacation home. You need to make sure you’re making an exchange – changing from one rental property to another rental property.
Another area that’s easy to make mistakes is with your qualified intermediary. Make sure you understand that professional’s role and the importance of letting him or her hold your escrow funds. If you touch any of the money that was made when you sold your relinquished property, you will immediately be subject to paying taxes. You cannot spend that money or move it into your own accounts without penalties. Such an action would completely void the 1031 exchange.
The Challenges of a 1031 Exchange
Many investors and real estate professionals are big fans of the 1031 exchange. It’s a straightforward and an effective investment tool to avoid paying taxes and help you save some serious money when you want to sell a rental property.
But, it’s not perfect. It also comes at a price, and you need to be prepared to deal with the potential downside of a transaction like this. First, there’s the pressure of deadlines. While it might seem like 45 days is plenty of time to find a like property, it might not be as easy as you think. Markets change all the time, and if you’re in a market where there’s very little inventory or a lot of competition from other buyers, you might have a hard time locating a good replacement property. In a seller’s market, it’s completely possible that 45 days may not be enough time to find a suitable replacement property.
What does this mean for you? It means that if you’re feeling pressured to find the right property, you might by something that you wouldn’t otherwise buy. You could settle for a property that isn’t quite right for your investment goals. This happens a lot as the days begin to dwindle, so be careful, people have the tendency to wait and find a replacement property later in the process or to grasp at any home that’s in a price range and available.
It’s still important to do your homework before you buy. It’s also important that you don’t wait too long when you do find a property that’s suitable for the exchange. We see a lot of investors who find a great replacement property but then they decide to think about it for a while or continue looking around, and then they don’t put the new home under contract. Ultimately, they might lose that property because they waited too long to make a move.
If you have a failed exchange, you have to pay taxes. Make sure you’re prepared to move, and make sure you’re ready to find and buy a replacement property as soon as possible.
There’s another potential danger, and it’s a more insidious issue that can trap investors into an endless cycle of 1031 exchange transactions. In this situation, you might have purchased a property and had some gains, so you sold it and did an exchange. Then, in two years, you do it again. Then, you do it three or four more times. After 10 or 15 years, you have deferred gains on hundreds of thousands of dollars. Maybe even a million dollars or more in profit. When you’re finally ready to unwind that final property and access the cash, your tax liability will be pretty huge. You have all of that gain over all those exchanges. You’re permanently locked in.
You need to understand your long term strategy. By using a 1031 exchange, you might not be able to completely liquidate your portfolio in 10 or 15 years.
We love the idea of a 1031 exchange, and we encourage investors we work with to use this tax tool as an effective way to defer capital gains and avoid depreciation recapture. Just make sure you are prepared for the pressure of finding a replacement property quickly. You need to understand the risk of making bad decisions under pressure and the long term impact on your portfolio.
Here are some quick tips to remember when you’re considering a 1031 exchange:
- Start the process of looking for a replacement property as soon as possible. Identify a suitable replacement right away.
- Consult with a tax attorney. An expert can help you navigate exchange process and protect you from mistakes.
There are some other things you can do to reduce your risk and we’d be happy to tell you about those in more detail. If you have any questions, please contact us at Mynd Property Management.