As real estate investors, finding and executing on profitable deals are the challenges we rise to time and again, but hanging on to one’s profits and building equity over time in a portfolio can be equally important to a an investors’ long-term success.
It’s typically at a deal’s exit when we have to be most aware of potential tax consequences, and any strategies available to mitigate them. You’re finally ready to sell that property you’ve hung on to for so many years: it’s in great shape, the local market has been booming, and it’s now worth double what you bought it for. This is why we love real estate investing! But it’s painful to think that the government will take a large chunk of the profit from all your hard work when you sell it. Well, your profits won’t take a hit if you use a 1031 exchange! For many investors this is the best, if not the only, big tax break (outside of tax-qualified plans) we get from Uncle Sam in this industry. And we’ve got great news–fortunately, it survived the latest legislative tax vote.
Possibly the biggest uncertainty surrounding tax reform — at least from the point-of-view of the real estate industry — was whether 1031 tax-deferred exchanges would be preserved. The industry is breathing a huge sigh of relief that the nearly 100-year-old reinvestment tax strategy will continue to be available to real estate investors.
The reason for the uncertainty was that many billions of dollars in capital gains taxes are avoided annually by investors utilizing 1031 swaps. Some members of Congress had targeted these exchanges as a way to finance tax cuts. Some see 1031 as overly generous to real estate investors. A New York Times analysis said that 1031 allows real estate investors to “keep flipping the properties until they die without ever paying any capital gains tax.”
In the end, the only change to the 1031 exchange law is that like-kind exchanges are now exclusive to the real estate industry. This means 1031 exchanges of personal property, collectibles, aircraft, art, franchise rights, rental cars, trucks, and heavy equipment, etc. will no longer be permitted beginning in 2018.
For those unfamiliar with 1031 exchanges, that provision of the tax code enables sellers of property to defer capital-gains taxes by reinvesting sale proceeds in similar types of properties.
Whenever you sell property and you have a gain, you generally have to pay tax on the gain at the time of sale. But IRC Section 1031 provides an exception — it allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Note that gains deferred in a like-kind exchange under IRC Section 1031 are tax-deferred, but not tax-free.
We know real estate investors who have put 1031 exchanges to very good use. An example:
In 2014, an investor named Bill, purchased a 100-unit apartment building outside of Washington, D.C. He paid $4 million for the property, and over the ensuing years worked on adding value to it. Tenant mix was improved, the condition of the building upgraded. He replaced the roof, the elevators, and made other improvements. Occupancy increased from 60% to over 90%.
Now, after several years of work and investment, Bill is entertaining an offer of $7 million for the property. If he sold, Bill would gross a $3 million profit on a three-year investment. Not bad! However, selling the property would expose him to maybe $900,000 in capital gains taxes. Ouch.
Enter the 1031 exchange. Bill is exchanging his apartment building for two new properties, a 40-unit apartment building and a high-end office building–both in cities that offer good investment value. Bill will be selling what he believes is a fully-valued property and buying new properties that will be easier to manage in locations offering greater appreciation potential. And there will be no capital gains taxes!
The only requirement of 1031 exchanges are that they be of “like-kind.” However, there is considerable flexibility: You can exchange raw land for an apartment building, or a farm for a strip mall for example. In addition, you don’t have to target a new property before selling as part of an exchange. That’s because exchanges can be delayed. In “Starker” exchanges (named for the tax case that allowed them), you use a middleman who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you.
In a Starker exchange, the replacement property(s) must be identified within 45 days after you transfer the “relinquished property.” The replacement property must be purchased no later than 180 days after the taxpayer transfers his original property.
There are some tax consequences involved in like-kind exchanges. As discussed, your profit will be deferred until you sell the replacement property. However, the cost basis of the new property in most cases will be the basis of the old property. You’ll want to sit down with your accountant to determine whether the savings of the like-kind exchange will make up for the lower cost basis on your new property.
After years of appreciation, savvy real estate investors are sitting on substantial profits. As they consider exit strategies for appreciated real estate, like-kind exchanges offer a tax-deferred way to sell and roll proceeds into new properties.
Thanks to Congress for maintaining 1031 exchanges for real estate investors!