When you decide to make some investment moves with your portfolio of rental properties, you might think about selling one or two. Maybe you want a home that requires less maintenance. Maybe you’re looking for rental properties in a different location or you want to add multi-family units to your portfolio.
You can buy and sell as you see fit.
One way to maximize what you’re earning is with a 1031 exchange. This program not only allows you to increase or adjust your portfolio, it also allows you to defer the payment of capital gains taxes on the properties you sell.
With property values climbing and sales prices off the charts, you’re likely looking at a big tax bill when you do sell an asset.
Unless you engage in a 1031 exchange.
With a 1031 exchange, you can keep more of the money you’ve earned and establish a more effective long-term investment strategy.
As Dallas-Fort Worth property managers, we get excited about the opportunities a 1031 exchange can provide for the investors we work with. We talk up this option a lot because we think there are several excellent reasons to use a 1031 exchange.
When you decide to re-invest the earnings you make off one property into another income property (or several), you have a great situation in which you can defer taxes and increase the value and strength of your rental property portfolio.
The process isn’t necessarily easy. There are some complicated conditions and timelines that need your attention. You’ll need to surround yourself with some real estate, accounting, property management, and tax experts to really maximize what you can earn and save through a 1031 exchange.
We thought it would be helpful to have as many questions answered in once place, so today we’re telling you everything you need to know about this program.
Defining a 1031 Exchange for Dallas-Fort Worth Real Estate Investors
The 1031 tax exchange has the blessing of the IRS.
This is a tax resource that’s named for Section 1031 of the IRS code. It allows for rental property owners to defer the taxes that may be due on the sale of an income-producing property by investing those profits into the purchase of another income-producing property.
Instead of walking away with cash after a sale, you’re setting those proceeds into an escrow account, where they’ll be accessed when you buy something else.
Most investors expect capital gains taxes when they sell an investment at a profit. But, if you’re willing to use the proceeds from the sale of your rental property to buy another rental property, you won’t lose any of those proceeds to taxes.
This is important to understand:
The 1031 exchange does not cancel what you owe to the IRS.
It merely defers the required payment of what is owed.
Rules for 1031 Exchanges
The 1031 exchange is advantageous, but it’s not easy to navigate, especially in a market like this one, where inventory is low. You have to exchange like properties for like properties when you’re taking advantage of this resource.
What does that mean? It means you’re sticking to rental property investments only. You cannot sell a rental property and avoid taxes by purchasing a vacation home for your family. It has to be income-producing property with a value that matches or exceeds the property you’ve sold.
Deadlines are strict.
- If you’re going to do a 1031 exchange, you have to identify the property or properties you want to buy within 45 days of closing on the property you sold.
- You also have to close on the new deal within 180 days of selling the original property. The entire transaction must be completed within those 180 days, otherwise you’ll be liable for taxes.
The exchange has to be for a like-kind property, which is not defined by its quality or grade. You can exchange a $600,000 single-family home in the suburbs for two or three apartments in a multi-unit building in a downtown Dallas neighborhood, for example.
You don’t have to buy a single-family home if you sold a single-family home. You don’t have to exchange an apartment building for an apartment building. A condo can be exchanged for a commercial building, for example, or industrial property can be exchanged for residential.
Bu, here’s what you cannot do.
You cannot exchange real estate for stocks or a pricey collection of wine or original Renaissance art. Those investment exchanges do not meet the definition of like-kind property. You cannot hold property for personal use or for resale, either.
Pay attention to those timelines. In a market as active as this one, you’ll need to move quickly to find a replacement property before you sell the property you have. To receive the full benefit of a 1031 exchange, your replacement property should be of equal or greater value. You must identify that replacement property within 45 days of selling the initial asset. Closing on the sale of the new property must occur within 180 days of the initial sale.
Three rules define identification and timing, and your requirement is to meet at one of the following:
- Identify three properties as potential purchases regardless of their market value. This is known as the three-property rule.
- Use the 200 percent rule, which allows you to identify unlimited replacement properties as long as their cumulative value doesn’t exceed 200 percent of your sold property’s value.
- Identify as many properties as you want as potential purchases as long as those you acquire are valued at 95 percent of their total or more. This, predictably, is called the 95 percent rule.
Remember that you have 45 days to identify replacement properties and then 135 additional days to close. Time is of the essence because if you don’t manage to identify the replacement properties or close before the deadline, you’ll be responsible for paying the taxes you’re trying to defer.
Working with a Qualified Intermediary
You need a qualified intermediary in order to successfully buy and sell property through a 1031 exchange.
Under section 1031 of IRS law, any proceeds received from the sale of a property remain taxable. So, to effectively and lawfully avoid paying those taxes during this transfer, you need to hand the money you earn from the sale of your property over to a qualified intermediary. As the seller, you cannot ever touch that money. This is an important aspect to keeping the 1031 exchange accessible and effective. If you bank even a small portion of the proceeds from a sale, the 1031 exchange cannot move forward.
The qualified intermediary is a professional or a company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property.
Don’t turn to your property manager. You don’t want the qualified intermediary to be your sister or your neighbor. Keep yourself impartial by working with a qualified intermediary you do not know. The law requires that this role is filled by someone with whom you have no business or personal relationship. This ensures the integrity of the exchange and the process.
Dallas-Fort Worth Investor Benefits
Why should you do this?
Because you can release a property without paying capital gains taxes. If you’ve wanted to sell a property but you weren’t thrilled about paying the taxes, this is one way to continue growing your investment portfolio.
Other benefits include:
- Growing your portfolio. With a 1031 exchange, you’re increasing the number of assets in your portfolio or diversifying what you already own.
- Establishing different income streams. When you sell one property and make a lot of money, you can use the proceeds to buy two or three properties instead of just one. This provides you with additional income streams.
- Eliminating expensive assets. If a particular rental property has stopped cash flowing because of all the maintenance and repairs that have been necessary, you’ll be able to take it out of your portfolio and replace it with a newer property that has less expenses attached to it.
- You can stay invested in the real estate market. Many investors hesitate to sell a property because they know it can be expensive to re-enter a growing market. With a 1031 exchange, you can sell that property and continue investing in real estate that will appreciate in value.
- You can capture depreciation. When you sell your rental property, those capital gains taxes are calculated based on the net-adjusted basis of your property, and that amount will reflect the property’s original purchase price, plus capital improvements minus depreciation.
This is a good idea for a lot of investors in a lot of situations.
We have a lot of experience helping owners and investors succeed with rental properties and investment portfolios. If you have any questions about the 1031 exchange or anything pertaining to property management in Dallas-Fort Worth, please contact us at Assign Property Management. We’d be happy to make a specific recommendation based on the current state of your portfolio and your plans for the future.