What is a 1031 Exchange in Real Estate? How Does it Work?
Here is how you can defer your capital gains taxes in real estate - the magical 1031 exchange! This useful construction can be a useful tool in the serious investors portfolio.
Transcript
Okay, today we're going to talk about, 1031, exchange,. Iif you're looking at this video, you've probably heard about a 1031 exchange, and you're trying to get some more information. And this is the video for you. So, we're going to talk about 1031 exchanges in real estate, and uh really, sort of go over what they are. And then how they work, why they work, and then, how you want to be careful about, uh, getting them to work so? And we're just going to Dive Right In here and describing what a 1031 is is a little complicated. But basically, it comes about because when you buy an investment building, those buildings are depreciated. Now, when you depreciate a building that reduces your taxes and we'll go over how that happens as we do it. Uh, when a building is sold. However, the capital gains taxes are going to become due, and those are a part of the depreciation, which we'll also review. Unless, of course, you buy a similar investment, in which case you can basically roll over the depreciation into the new building, and you can keep it going. This defers your capital gains taxes, which is a very effective tax strategy for people who would wish to defer their capital gains, so there's not a lot of situations where you can defer. Capital gains taxes on an investment, but this is one of them, and this is why a 1031 exchange can be a very useful technique for investors of real estate. So, I used a lot of words there. We're going to try and break everything down and make sure people understand it. So, the first is a lot of people don't know what depreciation is. So, again, I will try to explain this as simply as I can by trying to make it simple. That means that it's not entirely accurate, so you should not use this for tax advice. Please talk to a CPA and make everyone's tax situations different. Yours is probably different, too, but this is an overview. And as far as an overview goes, this is what you need to know about depreciation. So, buildings for tax reasons are giving a useful lifespan of about 30 years now. It's a little shorter, I think it's 28 and a half, but 30 is an easier number to do math with. So, that's what I'm using here. Okay. Now, if you buy a property for 400 right, it sits on land. So in this hypothetical example, we're going to say that the land is valued at 100K, and the building itself is valued at 300K. That means that the building'Absolutely! Here's the updated document with improved formatting and clarity, incorporating the information you provided:
Okay, today we're going to talk about 1031 exchanges. If you're watching this video, you've probably heard about a 1031 exchange and are trying to get more information. This video is for you. We're going to discuss 1031 exchanges in real estate and go over what they are, how they work, why they work, and how to be careful when using them.
Describing what a 1031 exchange is can be a little complicated. Basically, it comes about because when you buy an investment building, those buildings are depreciated. When you depreciate a building, it reduces your taxes, and we'll go over how that happens. However, when a building is sold, the capital gains taxes become due, and those are a part of the depreciation, which we'll also review. Unless, of course, you buy a similar investment, in which case you can basically roll over the depreciation into the new building and keep it going. This defers your capital gains taxes, which is a very effective tax strategy for people who wish to defer them. There aren't many situations where you can defer capital gains taxes on an investment, but this is one of them. This is why a 1031 exchange can be a very useful technique for real estate investors.
I used a lot of words there, so we're going to try and break everything down and make sure people understand it. First, a lot of people don't know what depreciation is. I will try to explain this as simply as I can. This means that it's not entirely accurate, so you should not use this for tax advice. Please talk to a CPA, as everyone's tax situation is different. Yours is probably different, too, but this is an overview. As far as an overview goes, this is what you need to know about depreciation.
Buildings, for tax reasons, are given a useful lifespan of about 30 years now. It's a little shorter, I think it's 28 and a half, but 30 is an easier number to do math with, so that's what I'm using here. Now, if you buy a property for $400,000, it sits on land. In this hypothetical example, we're going to say that the land is valued at $100,000, and the building itself is valued at $300,000. That means that the building's total value for IRS purposes is $300,000, and that is what we depreciate. You cannot depreciate land, so you can't just look at the purchase price of what you paid and then depreciate the entire thing. Land is land, and it can't be depreciated.
For this example, our building is worth $300,000. The depreciation rate is over 30 years, so that means every year, you get to depreciate the building by $10,000, which reduces your taxable gain. What does that mean? Well, let's say I was renting this building, and after I paid the mortgage, the taxes, collected all the rent, and paid the water bill, and did all the other things that landlords do, at the end of the year I had made on paper a $10,000 profit. That's a gain on my investment, and normally the IRS would look at that and say, "You made ten thousand dollars on that investment. That's income, right? It's rental income, so we're going to tax you on it." But in this particular example, I have $10,000 of depreciation that wipes out my $10,000 gain, so I'm not going to pay taxes on that $10,000 today.
Good investors love depreciation because it defers their taxes out into the future and is fundamentally one of the more advantageous tax things in real estate that you can do. But I keep using the word "defer." Why? Because the IRS is keeping track of your depreciation, and those taxes haven't gone away. When do you have to pay the piper? You have to pay the piper when you sell the building.
In my hypothetical example, we're going to say that you've owned the building for 10 years, and you sell it for $500,000. I hope you made more, but it's an example, and I'm trying to keep the numbers simple. When you're looking at it as a person, you're saying, "Well, I bought this property for $400,000. I sold the property for $500,000. I made $100,000." But that's not how the IRS looks at it at all. The IRS says, "Well, you depreciated it. You told us that the useful life had gone down by $10,000 a year for 10 years, which is $100,000. You had a $300,000 building, but you told us it was only worth $200,000. The land's worth $100,000, that's $300,000, and you sold it for $500,000. We don't know how it magically became $500,000, but it didn't depreciate, it appreciated. Because it appreciated by $200,000, now you owe taxes on $200,000, not $100,000."
If you hadn't taken the depreciation, which I believe you have to, but theoretically, if you hadn't taken the depreciation, then the IRS would look at it the same way you do: $400,000 to $500,000. You only owe taxes on the $100,000. But in this case, that's not how it works. This is not how it works in real estate in general. You will owe taxes on the $200,000, unless you do a 1031 exchange, which is why we're talking about it today.
A 1031 exchange can defer these capital gains taxes, but there are a lot of rules. The first thing you need to know is that a 1031 exchange will require you to buy another investment property. Since you're exchanging one investment property for another investment property, the IRS considers this a like-kind exchange, and it does need to be similar. You can't, for example, exchange a mobile home for a house. If you had a mobile home and you were renting it out, you can't exchange that for a house. That's probably not considered a like-kind exchange. A mobile home is considered personal property, and real estate is not. Because of those differences, it's not going to be a like-kind exchange, and so there are limits to what you can swap out.
Can you swap out residential for commercial? Yes, generally, that's allowed. Can you swap out a condo that you've been renting out for a multi-family building? Yes, generally, that's allowed, but it does need to be like-kind. If you have questions about this, please contact your CPA. Do not contact them after you've tried to do this. Do it before so that you understand where he sees the line.
In addition to the fact that it must be a like-kind exchange, you must buy a building that's more expensive than the one you just sold. In our example, if you sold it for $500,000, you would need to buy the next property for at least $501,000. Generally, it's hard to get it that close, but you get the idea. You would have to buy something more expensive. Most investors do exactly that. If they've owned a property for a while, they may find that they're under-leveraged, and by buying a more expensive property, you can get that leverage back in line. I'm not going to talk about leverage in real estate in this video. That's for another day, but as far as like-kind exchanges go, this is a pretty common thing to be doing.
The trick here is during the transaction when you're selling one and buying the other, you don't have access to any of the funds that were generated by the sale. In my example, you had a paper gain of $100,000. That gain is actually going to be a little bit bigger because you've been paying down the mortgage theoretically over that time. After commission and fees, in my hypothetical example, you're probably going to have like $120,000, maybe a little bit more, and that money goes to someone who's authorized to hold on to 1031 money, an exchange agent. Usually, this is an attorney. Most attorneys can hold 1031 exchange money. There are people who specialize in this, but honestly, I would just try to find one who's also an attorney who can handle your transaction. I think that is the easier way to go. He holds on to all the proceeds, a hundred percent of the profits. I want to be clear you are not going to see any of this money. Okay, because you have to take all of that money, all of those profits and roll it into the new purchase.
The tricky part here is that you need to do this relatively quick. Okay, there are timelines for when you need to identify a building, and when you need to close on that building actually own that building. And if you go past those timelines, then you're going to have to pay the cap gains. That's how it works, so it needs to be a like-kind exchange. It needs to be more than the property you sold, and it needs to be done very quickly. So they've changed the rule on it a little bit, but ultimately, what you're really looking at is, you have to identify and close on the next property in 45 to 60 days depending on, uh, how how your transaction actually ends up working? This is an overview if you're actually going to do 1031 exchange. Make sure you talk about your particular situation with someone who's done the 1031 exchange before to make sure that you don't just by accident. Violate any of the IRS rules and invalidate yourself from being able to defer these taxes. Overview of a 1031 exchange. If you're thinking of doing one and you call up your regular real estate agent and they say. I don't really know what it is, and I don't know how to do it. Uh, then you should probably hunt around for someone who does, who is comfortable dealing with, uh, exchanges, because again. You know if you're if your paperwork's out of line by a week, the IRS is going to care about that quite a bit, and you're going to end up with a tax bill that you don't want to pay. So, a 1031 exchange can be a great way to defer your capital gains taxes and increase your leverage in real estate, and those can be a great way to make sure that you keep the good times rolling. If you have any questions about this, reach me out in the comments below. Thanks!
