It’s been months since I closed on our new properties, but I promised to share more about the 1031 Exchange process and the benefits behind the effort! A bit of backstory to begin….
Back in the mid 2000’s, I was single and wanted to buy a house, so I did. Flash forward a few years and I was engaged and moving to the West Coast. Even though the house I had bought was bought to be my primary residence, I decided to keep it and rent it out after we moved. I spent 4 glorious years with ideal tenants and large appreciation in the area. Unfortunately, all good things must come to an end and my tenants decided they wanted to buy their own house and move out. I quickly realized that the property was going to be a bigger liability once vacant and decided that I should capitalize on the strong year over year appreciated growth, so I began to research the 1031 Exchange.
Investopedia defines the 1031 Exchange as A section of the U.S. Internal Revenue Service Code that allows investors to defer capital gains taxes on any exchange of like-kind properties for business or investment purposes. Taxes on capital gains are not charged on the sale of a property if the money is being used to purchase another property – the payment of tax is deferred until property is sold with no re-investment.
There are a few key things to deciding whether to do a 1031 Exchange:
- The amount of capital gains tax you expect to defer.
- This process can be tiring and requires significant coordination. A coworker advised me that if you were to defer over $50,000 in taxes, then it would be worth it. Anything under that $50,000 isn’t worth the effort it takes to get it done. After completing this Exchange, I would say that’s good advice.
- Your future tax bracket
- This is a tax deferral strategy, so it assumes if you ever want to sell in the future, that you will be at the same tax bracket or, better yet, a lower tax bracket. Of course, no one knows what will happen with taxes in the future, so there are some assumptions you have to make here, based on your personal situation.
- Your desire to invest in additional like-kind property.
- The key to a 1031 Exchange is that is to be done with like-kind properties. The “rules” around this are fairly loose; however, you can’t Exchange a single family home for stock and you can’t Exchange a property titled in your personal name for a property titled in your business entity. The type of investment has to be like-kind and the person (or persons/entity) on title for the sold property needs to be the sole title on the exchanged property(ies).
An important (and required) partner in your 1031 Exchange will be your Qualified Intermediary. This person will help you be successful in completing this process and is required to handle all funds exchanged during this process. They will also help you with communication to key personnel and draft all required documentation for this process. QI’s typically charge between $750 to $1,000 for their services. The fee comes out from the proceeds of the sale.
The timeline behind a 1031 Exchange is likely the most important aspect to the process. There are some strict rules around timing and ensuring that all the pieces are lined up correctly will ensure success. I’ve broken this down into 3 sections: selling your property, getting your financing, and buying your new property. I’ll actually discuss this in reverse order.
Buying Your New Property
In today’s market, this is the hardest piece. You need to find property of like-kind by 45-days after the sale of your property. If you are purchasing multiple properties, you must follow one of the following guidelines:
- Identify up to 3 properties of any value with the intent of purchasing at least one.
- Identify more than 3 properties with an aggregate value that does not exceed 200% of the market value of the relinquished property.
- Identify more than 3 properties with an aggregate value exceeding 200% of the relinquished property, knowing that 95% of the market value of all properties identified must be acquired.
I opted to find 6 properties that were just slightly over the total value of the property I was selling. It should be noted that it’s important to do all due diligence on these properties, so you’ll want to factor that into your timeline and your desired end results. We had done significant leg work prior to putting the property on the market, so identification of these 6 properties were easier once needed. Overall, it took us about 6 months to find who we wanted to buy from, complete due diligence, and land on the 6 properties to list in our required document.
Getting Your Financing
This is also a key strategic piece to the Exchange. As you know from our previous blogs, appropriate leverage can be a powerful tool to building wealth; however, your individual situation will dictate how difficult this process will be. I opted for 6 individual loans at 70% Loan-to-Value to reduce the risk of market volatility. it took some time to find a lender that had the terms I was looking for, but worth the effort at the end of it all. I found a lender that waved all closing costs and included some pay-back-points to gain my business. It was worth it to them to secure me as a client and it was worth it to me to help strengthen the parameters of the deal! Shop around. And don’t be afraid to say no to a lender.
Selling Your Property
Once you are close to identifying your new properties to buy and have a lender that is ready to work with you, then you should prepare to sell your property. The key here is making sure you tell your realtor that you are doing a 1031 Exchange! They will need to interact with your Qualified Intermediary and understand your timeline.
You have 180 days after selling your property to close on the purchase on your new properties. If you do not meet this deadline, then the sale will complete per usual transaction rules (i.e. you’ll pay capital gains taxes like everyone else).
Overall, the process took me 9 months from the time I started to investigate doing a 1031 Exchange until the time that I actually closed on my new properties. It was worth the effort, but it took a lot of effort, so be prepared. At the end of it all, I’ve saved thousands in taxes and I’ve turned my appreciated growth asset into a great monthly cashflow!