While I am not a tax expert, there’s a significant benefit to real estate investing that I’d like to talk about today. The 1031 exchange is an IRS rule that is designed to allow real estate investors to defer capital gains taxes to some point in the future. It is called a 1031 exchange because this rule is listed in section 1031 of the Internal Revenue Code (IRC). Under the rules of the 1031 exchange, real estate investors can swap one investment property for another “like-kind” property without having to pay capital gains taxes immediately upon the sale of their initial property.
So, for example, with a 1031 exchange, you could sell a 12-unit apartment complex that you own and use the proceeds from the sale to go and buy another similar apartment complex. In this case, you wouldn’t have to give any money to Uncle Sam until some point in the future when you decide to cash out. This is how wealth is built over an extended period of time.
The government’s goal in creating this rule is to make it easier for real estate investors to keep investing in real estate throughout their careers. Real estate investors perform a valuable service to the country by helping people to have places to live. So, the government gives them a little bit of slack to make sure that they can keep doing what they are doing.
When it’s easier for real estate investors to sell and buy properties, it helps to keep the real estate market strong, which is beneficial for the entire country. Real estate investors benefit by being able to make investments quicker, tenants benefit by having more properties to choose from, and the government benefits because a stronger real estate market makes for a stronger country. So, ultimately, 1031 exchanges just make a lot of sense and are a win for everyone.
Let’s take a look at the biggest pros and cons of 1031 exchanges so that you can decide whether or not this strategy is right for you.
Pros of 1031 Exchanges: 1. Deferring Capital Gains Tax
The biggest pro of 1031 exchanges is being able to defer capital gains taxes. When you can defer capital gains taxes, it allows you to grow wealth faster, as the amount of money you started with into the first investment is now even more money than it was before. For example, if you invested $100k into a property and ultimately made $170k in 4 years, that’s a significant rate to grow your money at. Let’s say the capital gain tax incurred for that is $30k. The 1031 exchange allows investors to defer that tax and take the full return of their investment into the next deal. This can be repeated from investment to investment as your wealth grows. However, once you decide to use those funds in an investment, not under the protection of the 1031, you will have to pay the taxes; but if you’ve grown your wealth significantly enough, it’s not an expense you can’t afford.
2. Exposure to New Markets
Oftentimes, real estate investors want to get exposure to new real estate markets in the United States. It is frequently the case that certain real estate markets in America experience surges. Austin, Texas in the last five years is a perfect example of this. The 1031 exchange gives real estate investors the power to quickly unload current real estate investments so that they can get exposure to new markets in order to make better returns. 1031 exchanges can be performed anywhere in the country. There is no restriction based on state lines. So, hypothetically, a real estate investor could sell a property in Key West Florida and use the money from the sale invest in a property in Nome Alaska without having to pay capital gains taxes at the time of the sale. This is highly advantageous to real estate investors.
3. You Can Literally Keep Deferring the Taxes Until You Die
There is a saying that is commonly used by real estate investors: “swap until you drop.” What this means is that you can literally just keep swapping properties with the 1031 property exchange until you die, deferring capital gains taxes the entire time. The best part is, you can leave the properties to your heirs and they won’t have to pay the accumulated capital gains taxes on the properties that were used in the 1031 exchange. Instead, they will inherit the properties in a “step-up” basis. This means that they will inherit the properties at the current fair-market price of the asset. All of the capital gains that have accumulated up to that point will simply vanish. It is for this reason that many people choose to use 1031 exchanges as vehicles for building generational wealth. There is no limit to the amount of 1031 exchanges you can perform.
Cons of 1031 Exchanges: 1. No Access to Your Capital, You Have to Roll It
If you decide to move forward with a 1031 exchange, you will not be able to access the capital gains that you made from the sale of your property. You will have to roll them into your next investment. So, for example, let’s say you made $100k in capital gains from the sale of a 200-unit apartment building you invested in. If you have an urge to take that $100k and invest in a stock that you are very interested in, you will lose the protection of the 1031 exchange and have pay to pay taxes on your gains first. If you want to keep the protection of the 1031 exchange, you can only put the money toward a “like-kind” investment, meaning it has to be another apartment building similar in scope
2. You Also Have to Roll Over the Initial Investment, Not Just the Capital Gains
So, let’s say. you invested $100k and got $50K in profit from selling the asset. You need to roll over $150K, not just the $50K you made in capital gains. Some people make the mistake of only rolling over the capital gains and then land themselves in trouble for spending the underlying investment. Make sure that this doesn’t happen to you by rolling over the entire amount that you get from the sale of your investment property.
3. Complicated Structure
The 1031 exchange structure can be difficult for some people to deal with, especially if there are multiple people involved in the real estate investment. For example, if you invest with other people and only some people want to do a 1031 exchange, this can be a problem. If five investors own 20% each in the asset, and two want to take their money out, then either the three investors buy the liquidating partners out and then roll over 100% of the partnership’s initial investment and profits, OR, they need to separate the partnership in the title-holding company into two different companies: one that is rolling the funds over and one that is liquidating. The structure is a TIC structure. It is definitely possible to do this and to effectively deal with such a circumstance, but it can be a little more complicated than some people would like.
The Bottom Line
There's a reason why it's been here for 100+ years; it's a great vehicle to defer taxes and keep the real estate market strong. Real estate investors have been taking advantage of 1031 exchanges for generations, and if it’s a strategy you’d like to implement, it’s important to work closely with your CPA or a Tax Strategist to maximize its benefits. Understanding the 1031 exchange is important for growing your wealth and trading up to bigger, better real estate investments.
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About the Author
Ellie is the founder of Blue Lake Capital, a commercial real estate investment firm specializing in multifamily investing throughout the United States. At Blue Lake Capital, Ellie partners with both institutional and individual investors to grow their wealth by achieving double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
A defining factor of Blue Lake Capital’s strategy is founded in utilizing machine learning/artificial intelligence throughout the course of all acquisitions and asset management. This advanced technology enables the company to produce accurate and data-driven forecasting for all assets on a market, property, and even tenant basis. In doing so, Blue Lake is able to lead commercial investments with the full capabilities of today’s technology.
Ellie is the host of REady2Scale, a podcast that highlights the assets, processes, and strategies for the multiple approaches to successful real estate investing.
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.
You can read more about Blue Lake Capital and Ellie Perlman at www.bluelake-capital.com.