When dealing with real estate, we often hear the term “capital gain”. What exactly does that mean?
A capital gain refers to profit that results from a sale of capital assets like stocks, bonds and real estate. If the sale price exceeds the purchase price, the profit is called a capital gain.
These types of profits are often subject to hefty taxes. This is where a “1031 exchange” can be helpful, because it helps you defer those taxes. Named after Section 1031 of the Internal Revenue Code, 1031 Exchanges are a key concept that come up on your real estate exam. They’re also something you should understand in real estate practice, as they can really give you a leg up on your competition.
To start with, there are specific requirements which must be met for a 1031 tax-deferred exchange. In order to defer all of your taxes, you must reinvest in another property of equal or greater value. Tax-deferred exchanges cannot be used for “personal-use” properties and, under new laws enacted in December 2017, only real property qualifies for a 1031 exchange.
You must also identify your replacement property and complete the exchange within a specific time frame. After the relinquished property closes, the “exchanger” has 45 days to identify potential replacement properties and 180 days to acquire the replacement property. The exchange is completed in 180 days, it is not 45 days plus 180 days.
Here is why someone would want to do a 1031 exchange:
Let’s say an investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined taxes when the property is sold. Only $130,000 of that capital gain remains to reinvest in another property. If we assume a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 property.
If that same investor used a 1031 tax deferred exchange with the same 25% down payment and 75% loan-to-value ratio, they could reinvest the entire $200,000. That would allow for the purchase of an $800,000 property- a $280,000 difference!
As this example demonstrates, you can build your wealth faster by keeping all of your money working for you, rather than paying the taxes now.
In summary, a 1031 exchange is a way to defer the payment of these taxes- that’s why it is referred to as a "1031 tax-deferred exchange". Sometimes people say "tax-free exchange", but that’s NOT accurate because the tax is only deferred until the day you sell the property and choose not to invest the money into a new one.
Here’s an easy way to remember this concept: if the money touches your hands, you get taxed! If you do not touch the money, and instead reinvest it, it will NOT get taxed. It’s not “tax free”, because one day you’ll want to touch the money and go buy something nice with it- like a cookie.
1031 exchanges are not the easiest thing to do, which is why many real estate agents, lawyers and other real estate professionals specialize in different aspects of the 1031 exchange process. There are a lot of nuances that can make them very complicated. So this may be a great way for you to separate yourself from the pack- AFTER you get your license. For now, let's focus on passing the real estate exam.