1031 Exchange: The Most Important Thing to Know

Using a 1031 Exchange to grow your real estate portfolio faster using Uncle Sam’s money is a strategy that has helped millions of investors.

But of all the things you need to know about a 1031 Exchange, the most important thing is that it must be in place BEFORE you sell your investment real estate. The moment you receive your sale proceeds, it’s TOO LATE and you will have to pay the tax. Many investors new to this tax deferral method have discovered this after their sale and paid for it – literally.

The great news is that even if you are closing tomorrow or don’t know when you will close, it is quick and easy to start your exchange. Once you know what title company will be handling the transaction, the exchange can be initiated on your behalf by your Qualified Intermediary (QI).

Initiating your exchange with a QI prior to your sale is a rule that is a critical thing to keep in mind as you continue to learn about 1031 exchanges. I hope you will use the free online resources here at www.the1031investor.com as you explore this option.

The Note Closers Show Podcast

Dave Foster on The Note Closers Show

Dave Foster was recently featured on The Note Closers Show with Scott Carson. Dave and Scott talked about the great benefits IRC Section 1031 has to offer. It allows investors to sell a property and reinvest proceeds in a new property while deferring capital gain taxes. They discussed some of the ways you can use this process to help you invest in real estate and notes, how it can be used even if you have owner financing and what kinds of investment properties qualify. Anyone can do a 1031 Exchange so long as the process and principles are followed.

They also talked about how to minimize the top five risks in note investing, return on investment vs. return on time, and the role of the borrower filing bankruptcy and how it creates an additional opportunity for a note investor, among other things.

Listen to the episode at iTunes, Google Podcasts or on your favorite podcast streaming service!

Accepting Unsolicited Offers

Find out how a Bigger Pockets member was able to reinvest even his tax dollars when an unsolicited offer created an unexpected windfall. Click here to read the full article.

Maximize Your Real Estate Investing

Maximize your real estate investing with your own tax dollars using a 1031 exchange. With this process, you can defer capital gains tax on investment real estate when you reinvest in real estate. It lets you reposition, reallocate or increase your holdings using your own capital gains tax.

Originally, a 1031 exchange was designed to facilitate the movement of large tracts of agricultural land. Essential food growers who were land rich and cash poor benefited. The 1031 exchange allowed them to strategically reallocate their holdings to maximize yields.

Since then, the application of section 1031 was expanded to all real estate held for productive use. This includes real estate held for business, trade or investment purposes. This means it is now available to any such real estate investor wishing to defer paying tax on profits while continuing to invest.

A 1031, or like-kind exchange, gives you the freedom to reinvest all of your money – including your capital gains tax – for your own benefit. This is a powerful tool for any real estate investor looking to accelerate their portfolio growth.

When Does A Property Qualify For a 1031 Exchange?

If you’re considering a 1031 exchange it’s important to know if your investment real estate is eligible.

A 1031 exchange gives investors a way to defer paying tax on gain from the sale of investment real estate. This means that primary residences do not qualify for a 1031 exchange. A 1031 exchange is solely for real estate held for productive use in business, trade or for investment.

House flipping is also off limits. Section 1031 states that a property “held primarily for resale” does not qualify. This excludes fix and flips.

The good news is that like-kind, as defined by the IRS statute, allows for any type of investment real estate to be exchanged for any other kind of investment real estate. This means that if you’re selling a rental condo and want to use the proceeds of that sale to purchase a retail building, you are free to do so.

The power of a 1031 to shape your real estate investment portfolio using your own tax dollars is limited only by your creativity and desired outcome.

Can You Take Money Out Of A 1031 Exchange?

If you’re willing to incur some tax, you may purchase less than your net sale under IRS Section 1031.

And, you may take cash out without jeopardizing the entirety of your 1031 exchange.

However, if you want to purchase less than what you sold or take some cash out, then the IRS will call that “booty” and tax it as profit. The IRS is willing to leave its tax in the game, but they are expecting you to leave your profit in the game as well. So, there’s no taking your “booty” and buying an island without paying at least some tax.

The IRS considers this taxable because their interpretation is that the first dollar you take out is going to be a dollar of profit.

BRRRR?

Real estate investment bloggers and founders of investor networking site Bigger Pockets, Joshua Dorkin and Brandon Turney, created an acronym to describe a powerful business model for the long-term holding investor.

It’s called the “BRRRR” Strategy (as in, I’m shivering cold).

B- Buy

R- Rehab

R- Rent

R- Refinance

R- Repeat

BRRRR is all about buying real estate investments with the long-term goal of holding, fixing the property up, and getting a renter in it. When the property appreciates, you can access the additional dollars of equity to then go buy a new real estate property. When you use this strategy, you leverage yourself toward becoming a very serious real estate investor very quickly while using the 1031 exchange to defer capital gains tax. You can adapt that model very easily into a buy, rehab, rent, refinance, repeat, and then another r for “relax” for a period of time. This allows you to demonstrate your intent to hold that property. You could also add “reevaluate” to decide whether it’s time to sell the original property. This valuable strategy will help keep you on track with the 1031 exchange and help you keep in mind what you have to do in order to use this program lawfully.

What’s most important is that you begin the process with your accountants and other team members knowing that this is a property that you will be holding, not one that you are “flipping” and reselling. Once you’ve established your intent with the property, you can use the 1031 exchange to eliminate due taxes and transfer them to your next investment.

Dave Foster Guest Interview On The Real Estate Nerds Podcast

          

You can also listen on  iTunesStitcherPlayerFMSpotifyGoogle Play and TuneIn.

Renting to Yourself and 1031s

We all would like to have our cake and eat it too. For a real estate investor that might look like having a rental property and a primary residence all in one. Many folks would love to take advantage of the tax deferral for investment properties found in 1031 exchanges and then use the property as their primary residence.  And the idea of living in the property but still treating it as an investment by “renting to myself” comes up frequently.

Renting to yourself. is a tricky business that can land you in hot water very quickly.  If you simply move in and start paying yourself rent after a 1031 it’s very clear that your intent in purchasing that property was not to buy an investment property but to purchase your primary residence – 1031 disallowed.

You could set up an LLC to rent to yourself, but if that LLC is a disregarded entity (meaning that it doesn’t file its own tax return) the IRS will ignore the entity and say that you are the taxpayer for 1031 purposes. So, you would again be renting from yourself. And the whole intent issue once again rears its head.

If the LLC is a regarded entity with its own tax return and you are more than half member, then you are a related party to the LLC. You might be able to rent to yourself, but you better make it an arm’s length true rental. Collect the rent, declare the rent, etc.

Another issue, however, is that If you do that, then you are generating taxable income for the LLC from yourself.  So you’re paying tax for the privilege of paying yourself rent.  And at that point, you should be asking yourself “why?” Why not simply hold the property with an outside renter for a year or two and then convert you’re your primary residence by moving in. There is no statutory requirement that you keep the property as investment forever.  And there’s actually specific IRS code allowing you to convert a property into your primary residence AFTER demonstrating your intent to hold for investment purposes.

By that time, you would have satisfied your 1031 intent requirements and are simply changing the use. No rent needed at that time.

 

How Much Should You Be Paying for a 1031 Exchange? [New Research!]

Check out Dave’s recent article on the cost of 1031 Exchanges on the Bigger Pockets Blog here.