Section §1031 of the U.S. Internal Revenue Code allows investors to avoid paying capital gains taxes after selling a property and reinvesting the proceeds from the sale into properties with similar or greater value.
Real estate takes many forms — but for 1031 Exchanges, qualifying real estate is “held for productive use in a trade or business or for investment.” Fix-and-flip projects, or “real property held primarily for sale,” does not qualify. However, a large list of properties does fit the requirements for these exchanges, including:
- Single family homes
- Duplexes/ triplexes, etc.
- Apartment buildings
- Townhomes
- Warehouses
- Distribution centers
- Factories
- Commercial buildings, including retail and offices
- Raw land
The IRS says, “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.” There are definite benefits to working with 1031 Exchanges to build your wealth because:
- There’s no limit on the number of like-kind 1031 Exchanges you can complete in your lifetime.
- No cap exists for the capital gains tax you defer.
- You can defer capital gains forever – which means you can legally avoid paying capital gains tax on any real estate sales… forever.
A Caveat Based on the Current Situation
Using 1031 Exchanges to grow your wealth is a great approach; however, there are several time restrictions that you must follow. First, you have 45 calendar days to identify your next property investment (up to three properties) after sell. Second, you have 180 calendar days after you’ve closed on the property you sold to take ownership of the exchanged property.
With the COVID-19 pandemic forcing the IRS to extend the 2020 tax filing deadline from April 15 to July 15, what does that look like for in-flight investors?
According to David Wieland, Realized Holdings CEO, “In the pre-coronavirus world, an investor who sold his or her net-lease asset during the first week of April [2020] as part of a 1031 Exchange would have had to find a replacement apartment complex or duplex by mid-May. In the COVID-19 environment, however, that investor has had more than two months to find that replacement asset.”
This extension — while initially appearing advantageous for 1031 Exchanges — carries its own risks. Demand for rental homes and duplexes, and other net lease and commercial real estate properties has far outpaced supply. Sellers are waiting for the economy to improve and some are pulling for-sale properties from the market.
Other current challenges in-flight investors face include:
- A disconnect between what buyers are offering and what sellers are willing to accept.
- Accessing banks’ strong capital reserves, as lending staff resources have been pulled to work on COVID-19-related programs.
- Stringent lending requirements that necessitate FICO scores of 700+ to qualify for mortgages.
- Lower loan-to-value agreements that mean higher equity requirements.
Building Wealth with a 1031 Exchange
You’ve decided to take advantage of this tax incentive and are ready to grow your portfolio quickly and build wealth. How does it work?
- Find your like-kind property, whether you’re taking a duplex and buying a four-plex or selling a single-family home and buying an apartment.
- A 1031 Exchange requires an intermediary, or 1031 exchange company that holds the proceeds of your sale until those funds are transferred to the escrow company handling your next transaction (i.e., your new purchase). You can’t touch the funds, otherwise the entire transaction becomes void.
- You’ve got 45 days to source and document a list of up to three properties you plan to purchase.
- The clock begins to tick again, granting you 180 calendar days to close on at least one of those properties, which must be the same cost or higher than the property you’re selling (and your loan amount must be the same or higher, too).
Benefits of a 1031 Exchange
This investment path allows you to liquidate investment properties that might be vacant or not generating monthly income freeing up your assets to invest in something else with a higher potential to generate more significant wealth.
The exchange is such that you can invest your profits without paying tax penalties (unless, of course, you liquidate everything and choose not to purchase another real estate property — then you will pay capital gains taxes).
If you continue to use the 1031 Exchange and roll profits into bigger or better investments, you can continue to do so from sale to sale and never pay taxes. Those who inherit your wealth also won’t pay capital gains taxes on those inherited properties — so you’re able to help support the financial future of your beneficiaries by leaving them tax-free investments.
If you want to learn more about how to grow your nest egg and build a greater, more financially secure future for yourself and your family, tune into the July 22, 2020, Hanson Zoomcast, moderated by NAI James E. Hanson’s Darren Lizzack, MSRE.
The session will feature five members of CREA United, including Randy Horning, Edward Kasperavich, Michael J. Lanni, Jr., Joseph Manzo, and Jonathan R. Mehl, Esq. sharing their expertise and guidance about:
- Building wealth using the 1031 Exchange process
- Minimizing tax exposure
- Real estate investment options
- Tax Planning Strategies
- Portfolio diversification
