Now that we are finally getting some clarity into the political environment over the next 4 years, questions are arising about what the new administration and Congress will mean for real estate investors. There is a lot of talk about Joe Biden and the Democrat controlled Congress eliminating the 1031 Exchange for real estate investors. This got me thinking more about the 1031 Exchange process and how beneficial it actually is. This post will leave politics on the side and just focus on what a 1031 Exchange is and some of the requirements to transact the exchange.
What is a 1031 Exchange?
The most basic definition of a 1031 Exchange is the swap of one investment property for another investment property that allows capital gains taxes to be deferred.
How does it work?
To complete a 1031 Exchange an investor would engage the services of an agency that is authorized to handle the transaction. During a 1031 Exchange the investor decides to sell a property and use the proceeds to purchase another "like kind" investment property. The agency handling the transaction will manage the transfer of funds to ensure that the investor never takes possession of the money since that would nullify the tax deferral.
What is the fine print?
As with anything that allows for a tax reduction or deferral, there are some rules to follow. Here are a few high level requirements for a 1031 Exchange. Definitely engage the help of a 1031 professional before trying to do this.
What are the timing requirements?
There are some very specific timing requirements to legally transact a 1031 Exchange.
What are the financial benefits of a 1031 Exchange?
The financial benefits of a 1031 Exchange are quite astonishing! The current capital gains tax rate for most investors is going to be 15-20%. So in essence each time you exchange up you have 15-20% more money to invest that would have otherwise been paid to the IRS at the sale of your previous property.
Example: Assume that you have an investment property that you bought for $400,000 and you are selling for $500,000. In a normal transaction, you would pay $20,000 in taxes and have only $480,000 to invest in your new property. With a 1031 Exchange, you get to invest that full $500,000. Where it starts to really get good is when that new property appreciates. If your new property appreciates by 10% the 1031 exchanged property would be worth $550,000 while the normally exchanged property would only be worth $528,000. Do this a few times and the difference really starts to add up.
An extreme example of this technique is how George Soros used a similar tax advantage to reinvest investor fees in his fund rather than pay taxes at the time the income was earned. Had he paid the taxes when the income came in and only reinvested what was left, his original $18 million would have grown to $2.4 billion. Instead, that original $18 million has grown to approximately $12 billion!! I don't think anyone will scoff at earning an additional $9.5 billion.
Will you ever have to pay taxes on these earnings?
Yes, the 1031 Exchange is a tax deferral technique, not a tax elimination. Eventually, you will have to pay the piper and settle up with Uncle Sam. There is still a great advantage here because you are growing your net worth at a significanty increased rate. Even when you settle up, you should have way more money in your pocket. There are advanced estate planning techniques to step up the basis on these investments when passing on to heirs and thus minimize taxation but that is a whole separate topic.
You may have thoughts and beliefs on the appropriateness of these tax provisions and whether to utilize them or not. Whatever you decide is best for you, it is important to at least know what options are available and make the best possible decisions.