Many real estate investors have expressed concerns about losing the ability to conduct a 1031 exchange following the passage of sweeping tax reform. Fortunately, this provision of the tax code – Section 1031 – was not eliminated. But it was altered. Investors can still use a 1031 exchange to defer capital gain taxes to sell, and “trade up” for real estate. However, the Tax Cuts & Jobs Act no longer allows investors to exchange personal property. A 1031 exchange is now limited to real estate.
Before the passage of the new law, the IRS permitted the exchange of both real estate and personal property in a 1031 exchange. For example, if you were selling a retail building with a laundromat, you could also sell all the business-related equipment (washers, dryers, etc.), and defer the capital gains on both the real estate and the equipment. But not anymore, thanks to the Trump administration.
What Assets Can Be Used Now in a 1031 Exchange?
All types of real estate held for investment or business purposes can still be used in a 1031 exchange. For instance, land can be exchanged for an apartment building, SFR, duplex or commercial real estate. The property being sold is called the relinquished property, while the asset being acquired is called the replacement property. In essence, a 1031exchange, also known as a “like-kind” exchange, allows you to take the equity of one property and exchange it into a new property or properties within a certain time frame – 45 days.
While each 1031 exchange is unique, the IRS has several rules regarding how it works. You can purchase a maximum of three replacement properties without regard to fair-market value or follow what is referred to as the 200% rule. If you purchase more than three properties, the total aggregate value of all replacement properties cannot exceed 200% of the relinquished property value.
Relief from High Taxes in Coastal Markets
Salvaging the 1031 exchange for real estate purposes is great news for single-family rental (SFR) investors. It’s especially welcome news for investors who plan to buy a traditional home, or have an existing mortgage in an expensive, coastal market. These individuals will incur the greatest pain from the Tax Cuts & Jobs Act. Investors who reside in the Bay Area, Seattle, New York City, Los Angeles and other expensive regions, now have a limited ability to deduct mortgage interest on their primary residence. Their ability to deduct state and local property taxes is also diminished. This will be most damaging to taxpayers in California and New York State, where property taxes are among the highest in the U.S.
“The 1031 exchange looks even more attractive to real estate investors with tax reform now in place,” explains Don Ganguly, CEO of HomeUnion. “It’s a great way for coastal investors to reduce their overall tax burden, which is important as inflation starts to rear its head.”
Time Is Critical
Time is a critical when executing a 1031 exchange. After selling an investment property, you have 45 days to identify a replacement property or properties. Then, an investor only has 180 days after the close of escrow to acquire the replacement asset. Be prepared and pay close attention to these time frames. An investor should shop for a replacement property before their existing asset sells. In addition, the faster the transaction takes to close, the more likely an investor is to avoid rising interest rates.
“With the new tax law in place, a 1031 exchange is the best way to defer taxes on real estate, and it’s one of the best ways to build wealth through real estate,” adds Ganguly. “If the property you had originally purchased is paid for free and clear, you could use the capital to reinvest with leverage on a larger real estate opportunity.”
Instead of putting all your eggs in one basket, you can use proceeds from your real estate sale and invest them in several residential real estate opportunities. By investing in different metro areas, you can add an extra layer of diversification to your portfolio, as each market has its own set of microeconomic conditions.
Is a 1031 Exchange Right for You?
If you’re planning to sell a property soon, a 1031 exchange is an excellent way to reduce your overall tax burden. Using this strategy means you could defer taxes, provide diversification to your portfolio, and continue to build wealth through real estate.
If you’d like to learn more about how you can create a 1031 exchange strategy, schedule a consultation with us today.