Andrew Carnegie, one of the wealthiest men in the world in the early 20th century, famously said that 90% of all millionaires become so through owning real estate. His words are as prophetic today as they were back then. One of the time-tested paths to building generational wealth is indeed through investing in real estate.
Investors should know that one of the strategic real estate investment tools available today is a “tax-free exchange” (IRC Section 1031). This replacement vehicle is worth considering if you earn over $200K a year. Section 1031 allows you to start with a relatively modest real estate investment (such as $50,000) and turn that into a potentially substantial income property over time, deferring taxes along the way.
So what exactly is this section 1031? And how can you take advantage of it? Let's take a deep dive.
What is a Replacement Property and Like-Kind Property?
IRC section 1031 is one of the most beneficial sections of the US tax code. It allows for the deferral of taxes when an investment property is sold while another replacement property is bought. The tax savings alone are so monumental that you don’t need any other justification for a 1031 exchange; however, there are several other benefits to it as well.
Think of the 1031 exchange as a wealth-building tool that gives you (the investor) free access to a property’s appreciation to increase your buying power with no tax penalties. With more buying power, you can buy high-quality assets, diversify into new property types, expand your portfolio, and even implement a unique ownership strategy.
This ability to defer capital gains tax over several decades of real estate transactions allows you to strategically build wealth that you can pass down to multiple generations. In addition, your heirs can pay little to no tax on a stepped-up cost basis.
The IRC section 1031 or 1031 exchange works magic so that you may never have to pay capital gains tax on your real estate investment profits. That’s right; you can roll that capital back into another investment without paying capital gains tax. And you can keep rolling it over and over again.
For those wondering what replacement property is– it’s any real property (land or buildings) that you buy or acquire during a capital gain tax-deferred exchange. This includes section 1031, where real estate investors can use the proceeds of a sale to purchase like-kind property for business or investment purposes of higher or equal value. The replacement property is the one that you are exchanging or acquiring into the 1031 exchange.
Like-kind properties are those of the same character or nature, even if they are of different quality or grade. A like-kind property can be held for business, trade, or investment purposes under section 1031 and can be exchanged without incurring any tax liabilities. This means both properties in a like-kind exchange must be for investment or business purposes; personal property doesn't count.
To get the most out of a 1031 exchange, your replacement property should be of higher or equal value. The replacement property for the assets sold must be identified within 45 days, and then the exchange must be concluded within 180 days. Both properties must be located in the US.
There are three rules that can be used to identify qualified 1031 replacement vehicles; you must meet at least one of these rules:
The 95% rule: It allows you to identify as many properties as you wish – only if you buy properties valued at 95% of their total value or more.
The 200% rule allows you to identify an infinite number of properties – only if their cumulative value does not surpass 200% of the value of the property sold.
The three-property rule allows you to identify three properties as potential purchases no matter what their market value is.
What Does This Mean in the 1031 Exchange World?
Many other names, including a tax-free exchange, a like-kind exchange, a tax-deferred exchange, and a swap, are known as the 1031 exchange. Several real estate transactions meet the criteria and are eligible for a 1031 exchange. According to the IRS regulation 1.1031(k)-1(a):
“A deferred exchange is defined as an exchange in which, under an agreement, the taxpayer transfers property held for productive use in a trade or business or investment (the ‘relinquished property’) and subsequently receives property to be held either for productive use in a trade or business or investment (the ‘replacement property’).”
As mentioned earlier, the 1031 exchange – if used wisely – can turn a few thousand dollars into several million in only a couple of decades. Moreover, through a series of sales and purchases in which you defer capital gains taxes and depreciation recapture taxes with each transaction, you can eventually eliminate most, if not all, of the deferred tax liability.
With every transaction you perform, you keep the deferred taxes, include them with your investment funds, and use them to purchase more property. Therefore, as a tax and estate planning tool, the 1031 exchange should be addressed.
Suppose you are new to the IRC Section 1031. In that case, you may come across some opinions that it is a “loophole," as claimed by some people. It’s not. A loophole is “an inadequacy or an ambiguity in the law or a set of rules”; it’s meant for evasion. Some salesmen and writers want you to believe that the IRS didn’t know what they were doing and just messed up, and now they can’t fix it so that you can take advantage of the situation.
This is not accurate. Please don't buy into that. Section 1031 reflects long-standing government policy that is equally accessible to every American. It being “tax-deferred” means that you will not be taxed on the profit from the sale of your investment at the time of purchase as long as you agree to invest the net sales proceeds into another like-kind property of equal or more excellent value within 180 days.
This arrangement benefits both you and the government. It helps you because you don’t have to pay capital gains or depreciation recapture taxes when you sell, and you can keep that money to invest in more or more extensive properties. It benefits the government because the economy is stimulated with investments that produce other additional income and sources of taxation. Technically, the government knows that the taxes will eventually be paid; the payment is just being put off for now.
There are several ways to avoid ever paying the accrued tax liability, and you can do this while following all the rules. The procedures to do this are all laid out in the Treasury Regulations.
How Does it Work?
We'd like to present a simplified transaction overview to understand the tremendous power available to an American taxpayer selling property and using the Section 1031-like-kind exchange.
The first thing you need to understand about deferring payment of capital gains taxes is that when you do, the money you’re keeping and then investing in a new property is not your money. And it’s not a loan either; it’s better than a loan because you don’t have to make any monthly payments or pay interest. You’ll eventually settle the money to the IRS when you are ready to pay. Some may never end up paying it!
Simply put, you’re using the IRS’s money to invest in real estate. They are okay with it and have designed Section 1031 specifically for this purpose. But wait, it gets even better.
You’re also using the IRS’s money as the basis for borrowing three times that amount, ending up with a real estate investment that you bought with other people’s money (the IRS’s 25% and the lender’s 75%), but owned by you, managed by you and used to build your real estate portfolio, even though you put none of your own money in it.
This happens because when the typical lender makes a real estate investment loan, the lender requires the borrower to provide a down payment of 25%, and then the lender will loan the other 75%. These percentages vary by region, personal circumstances, and by market conditions. Sometimes it is 80-20%, and sometimes it is 70-30%, and so on. We are using 75-25% as an average. You can adjust the numbers to fit your situation.
Let’s Understand This With an Example
Consider that you have sold an investment property that you have owned for a few years, such as a multi-family property, and made a profit of $250,000. You will owe a capital gains tax of $50,000 (because the highest capital gains tax rate is 20%), which you will pay to the IRS. But, instead of paying that, you defer payment of the capital gains taxes by purchasing a replacement property and engaging in a section 1031-like-kind exchange.
In other words, you use your net sales proceeds to buy another investment property of equal or more excellent value within 180 days. So you don’t have to pay the IRS the $50,000 in capital gains. Instead, you keep that sum to yourself. And that $50,000 tax liability to the IRS disappears into the replacement property and stays there until you sell that replacement property.
When you eventually sell the replacement property, you can continue to delay the tax liability on this current transaction and the next transaction by doing another section 1031-like-kind exchange.
One important thing to note here is that you can’t take any money that represents your capital gains and use it for anything you want. This is because to defer all of the capital gains tax, the net sales proceeds must all be rolled over into the replacement property. There are, however, some ways to free up that money legally, which we discuss in another Blog Post.
Let’s assume you walk away from the closing table with $250,000 net sales proceeds, the same amount as your capital gains. There was no mortgage to pay off (and we are not counting the transaction costs here for simplicity in explaining the process).
To track that $50,000, let’s say you buy two replacement properties with all your net sales proceeds instead of just one. You use $200,000 of your $250,000 capital gains as a down payment, get a 75% loan for $600,0000, and buy one investment property for $800,000.
Now you take the remaining $50,000 and use it as your 25% down payment, get a loan for $150,000, and you have a total of $200,000 to buy another investment property. So ultimately, your $50,000 ends up being $200,000.
Do you want to know what the result of that $50,000 investment looks like? Even if you only keep the investment for ten years, it is incredible what happens.
Assume that you use this $200,000 in funds to buy an income property that will generate cash flow, pay all of your expenses, including property taxes and principal and interest on the note, and provide for capital expenditures. This should be your strategy in any investment. Also, assume a conservative 6% annual appreciation in value for the property, although based on historical data, the actual figure is, on average, 6.7% per year.
That said, in 10 years, it's estimated that the property will increase in value from $200,000 to around $358,170.
Year 1: $200,000 x 1.06 = $212,000
Year 2: $212,000 x 1.06 = $224,720
Year 3: $224,720 x 1.06 = $238,203
Year 4: $238,203 x 1.06 = $252,495
Year 5: $252,495 x 1.06 = $267,645
Year 6: $267,645 x 1.06 = $283,704
Year 7: $283,704 x 1.06 = $300,726
Year 8: $300,726 x 1.06 = $318,770
Year 9: $318,770 x 1.06 = $337,896
Year 10: $337,896 x 1.06 = $358,170
*The numbers had been rounded off to the nearest dollar
The fair market value of $200,000 has increased to around $358,170, an increase of 179%. Also, your equity of $50,000 has increased by 475%. In 10 years, the $150,000 loan, using a 4.5% interest rate for a 30-year mortgage, will be paid down to about $120,000. Remember, the rental income is paying the interest and principal on the mortgage.
And this is just one 1031 exchange; you can do more than one in 10 years and reap even bigger rewards.
Is it Prudent to Invest in a Replacement Vehicle?
As an investor, there are several reasons why you might want to consider using a 1031 exchange:
Tax deferral is the most significant benefit of doing a 1031 exchange instead of just selling one property and buying another. With section 1031, you can defer capital gains tax and free more capital for investment in the replacement property. This way, your money starts working for you, and you don’t have to pay out a significant percentage of that equity in taxes which is fantastic during times of severe inflation.
When you own a property, you can write off the depreciation to compensate for structural aging and wear and tear deterioration. The IRS recognizes that an investment property (only buildings, not land) depreciates at the rate of 3.6% annually for 27.5 years. When you sell your investment property, if you have any gains, you will have to pay substantial capital gains taxes at the time of its sale.
But as explained earlier, you won’t have to pay any taxes at the time of sale if you implement the 1031 exchange properly. Using this strategy, your CPA may choose to reset the depreciable amount of the property to a higher value that would give you a higher tax benefit.
Trade Up to a Higher-Returns Property
The 1031 exchange also enables you to trade up to a portfolio of properties or a single property with greater returns that better match your investing goals. And the good news is, you don’t need to pay any tax on the new investment until you sell – unless you decide to do another 1031 exchange.
For example, you can double your cash flow from your investment property by executing a 1031 exchange from a Duplex into an extensive portfolio of multi-family apartment buildings. Or, if you currently own a single-family home in a high-tax, highly appreciated market like New York, you can use the 1031 exchange to buy a portfolio of rental properties in more affordable/lower volatility states with better cash flow, thus generating higher returns over time.
Talk to Pivot Professional Partners to Learn More About 1031 Replacement Vehicles
Pivot Professional Partners is dedicated to helping investment and business property owners defer their capital gains taxes on property sales using IRC Section 1031. We will provide valuable insights on how to get the most out of your hard-earned equity with different tax deferral strategies, including the 1031 exchange. If you have any questions or concerns about replacement properties, contact us at (561) 444-3371 or contact us online.
IMPORTANT: While 1031 is considered a tax strategy, we are not tax advisors, and you should consult your tax professional before investing.