If you're a real estate investor looking to grow your portfolio, defer taxes, or shift your investment strategy without taking a tax hit, pay attention.
Imagine turning a $40,000 plot of dusty Texas land into a gleaming San Francisco apartment building - without paying a dime in taxes. That's just one example of what I’ve done using the power of 1031 exchanges.
Disclaimer: This article is for educational purposes only. Consult qualified tax and legal professionals before implementing any strategy.
1031 exchanges apply after you sell an investment property and have a taxable gain. If you then buy a second property of equal or greater value, you defer the capital gains taxes. Technically, the exchange must be of “like kind”, which in real estate is broadly interpreted to mean any real estate held for investment that is based in the US.
Investors love 1031 exchanges. Why?
You’re using the extra equity you would have paid Uncle Sam to grow your portfolio.
You can (eventually) add new debt to the new property and get cash tax free.
You gain portfolio flexibility, allowing you to restructure, rebalance, consolidate, or fragment your real estate investments based on changing market conditions or investment goals.
You can combine this tax strategy with the “step up” in basis tax estate planning strategy – so that when you pass along this real estate to your heirs, the capital gains are gone like a rabbit into a magician’s hat. Hence the name “Swap till you drop”.
Let’s use an example. In 2015, as you walked through a local neighborhood that you used to avoid at night, you saw the towering frames of a new condo building. You were feeling frisky, so you invested in a sweet modern condo for $350,000, and due to the magic of depreciation (more on that later), now have a tax basis of $300,000.
In 2024, as you predicted – the grungy neighborhood corner store is now the coolest espresso place in town, featuring avocado toast, great tasting coffee, and a long line of hipsters out the door! You sell your condo to a young couple for $550,000. After paying some deductible “transaction costs” – including commissions and title insurance, you’re left with $500,000. As long as all proceeds from the sale go towards the new property, and you spend more than $500,000, you don’t pay any capital gains.
Note: There's a big assumption – you did the paperwork correctly. This tax delaying strategy has strict time limits and paperwork requirements at every juncture, starting with a replacement property identification form, due 45 days after you sell your first property.
As you race against the clock to tour and identify properties, you'll likely feel a mix of excitement and anxiety. Often 1031 exchanges can feel like a game of hot potato where the potato keeps growing and getting hotter, and you get burned (by taxes) if you can't pass it along in time.
Just remember these key points:
-You have exactly 45 days including weekends, from closing on your original property to identifying your replacement property
-You can identify up to 3* properties and pick any combination (*more than 3 under certain circumstances).
-You must close on new properties within 180 days of selling your original property.
-To defer 100% of your tax, you must buy a property of equal or greater value.
-You will use an “qualified intermediary”, hired before you sell your original property, to comply with the paperwork and tax rules. They hold your funds rather than release them to you at close.
Now that you understand the basics of the 1031 Exchange, in the next article we’ll dive into the strategies I’ve learned from the trenches.