Education, Strategy

The 1031 Exchange: Legally Deferring Capital Gains Tax

By Matt Picheny

No one wants to pay taxes when they sell a property they’ve invested in. And while there’s no magic wand for avoiding that tax burden, there is a way to defer the taxes until later. And that’s where a 1031 exchange comes in.

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What is a 1031 Exchange?

A 1031 exchange is a way of deferring the payment of taxes when selling a property.

It’s considered an exchange because you essentially replace one property with another within a short period of time. This sell-buy exchange means you do not need to pay capital gains tax immediately on the sale. Instead, that tax is deferred. 

The replacement property must have the same or greater value than the old property, or else you’ll need to pay taxes on the difference.

To do a 1031 exchange, you need to:

  • Identify a similar property to buy within 45 days of the closing of the sale of the property.
  • Close on the new purchase within 180 days of the sale of the first property.

These are quite tight timeframes, so it’s smart to look at options for replacement property before you put your current one up for sale.

The rules of the 1031 exchange are strict. You must meet both of the time requirements, and you also have to engage the services of a qualified intermediary, also known as a “QI”. 

The QI holds the proceeds from the sale and will disburse the proceeds on your behalf when you purchase your replacement property. Naturally, the QI takes a payment for this service. 

Remember everything I share is for educational purposes. Regulations change over time and there are nuances to all of these things, so you want a team of professionals, like a QI, who are experts in this, helping you along the way. 

Now, this all might sound like a lot of effort and stress, so is it worth it? 

What are the benefits of a 1031 Exchange? 

Quite simply, a 1031 exchange means you can defer paying Capital Gains Taxes when selling a property. 

By deferring the tax, this leaves you with more money to invest. 

Even better, it is possible to do multiple 1031s through a series of buy-sell chains, each time meaning that the capital gains tax is deferred. 

In fact, you could keep doing this for the rest of your life, as there’s currently no limit on the number of 1031 exchanges you can do. 

Such exchanges exist because the U.S.government wants there to be housing available on the market. They want to incentivize investors to keep their money in the real estate market, hence they permit deferring taxes due on gains made from selling properties, so long as appropriate rules are followed. 

Can a 1031 Exchange mean avoiding Capital Gains Taxes forever? 

Potentially, yes. As there’s currently no limit on the number of 1031 exchanges you can do. It’s possible to keep buying and selling properties until you die, all the while deferring your capital gains taxes.

If that happens and your property passes to your heirs, they can take advantage of something called step-up in basis, which offers them a route out of paying capital gains taxes. Let’s explain with an example.

Say you buy a property for $500,000 and sell it for $700,000. You would normally need to pay capital gains taxes on the $200,000 of appreciation. 

But if your heir inherits the property instead, they inherited it at what is considered the fair market value at the time of inheritance. In this example, $700,000. 

So that original $200,000 of appreciation does not apply to them. This means that they could sell the property at $700,000 and not have any capital gains taxes to pay. But they would pay taxes on any amount above their $700,000 basis. 

Note that we’re talking about capital gains tax only. Inheritance tax and any other relevant taxes would still be due, so your heirs aren’t getting a completely free ride. Sorry to any greedy grandkids that are reading this article.

1031s in a syndication

I’m often asked whether it’s possible to do 1031 into a syndication.

The complication here is that whatever name is on the title of the property being exchanged must be the same name on the new property, or else the 1031 exchange isn’t valid. 

So if you’re John Doe trying to do a 1031 exchange into a Main Street LLC syndication, well, that’s going to be a problem. The syndication has its own entity and tax ID. Since it’s different, it won’t count as a 1031 exchange. 

But there is a workaround! This relies on something called a Tenants In Common, often referred to as a TIC.

1031s and TICs

A TIC allows a property to be held in more than one person or entity’s name. So one of those names could be the syndication name and the other could be whatever entity is bringing in the 1031. 

However, this isn’t just as simple as adding an extra name to a legal document –far from it. There are a lot of legal hoops to jump through, and in practice it might not be worth it unless you’re investing a large amount (I’m talking about $1,000,000 or more).

Aside from the legal hoops, I have a philosophical concern with this practice. 

I believe a syndication should have a stated goal, such as “double our money in 5 years or less and then exit.” But what if one of the tenants in common doesn’t want to sell because that would put a huge tax burden on them unless they 1031 into another deal within the 45/180 day framework that we mentioned before?

It’s easy to see how there could be conflicts of interest here. So, you need to be in very clear agreement before getting into a TIC and doing a 1031 exchange.

1031 out of a syndication

In most cases, you can’t exit a syndication and 1031 into another property, though there are exceptions.

For this to work, all investors would need to transfer into the new property, otherwise, the entity is no longer what it was and that creates legal complications.

Some syndications are set up with a 1031 exchange in mind, so it may be possible to get involved in investments like this. Though you need to be sure of what you’re doing and you need to have good advisors on your team who can guide you as needed. 

A 1031 exchange is often a smart way for real estate investors to kick tax payments down the road, but keep in mind there’s been talk in political circles about 1031s being removed, so there’s no guarantee of being able to do this forever.

And besides, you need more than just one tactic to extract the most value from real estate investments. 

Depreciation can provide some great tax benefits, so you may want to check out some of my videos that talk about that too. 

And you can always join me backstage, at Picheny Investors Club for all of my best insights about passive investing.

The information provided on this website is not advice and does not purport to be a substitute for professional adviceYou should seek out the services of professionals who are experts in the fields of investment, legal, and accounting concerning your specific situation. The author disclaims any responsibility or any liability, loss, or risk, personal or otherwise, which is incurred as a consequence, directly or indirectly, of the use and application of any contents of this website.