JLM Blog | What is a 1031 Exchange?Real Estate News, Updates, and Tips
Article written by Jason Lee
A 1031 Exchange, also known as a Starker Exchange, or a Like-Kind exchange is a powerful real estate investment tool that investors have leveraged over many years in order to defer capital gain taxes.
The 1031 exchange is a term coined by the IRS, under section 1031, stating that an investor can “defer” paying capital gains taxes on an investment property after it is sold, as long as the investor purchases another “like-kind property” with the profits from the property that the investor has sold.
There are strict IRS guidelines to this powerful tool that all investors must follow, or else the 1031 exchange will fail, and the investor will ultimately have to pay the capital gains taxes. I will explain all of the guidelines in full detail in a later section.
The Benefits of a 1031 Exchange
Real Estate investors have used this tool to expand their wealth significantly ever since it was created by the United States Congress as a part of the Revenue Act in 1921.
The first benefit, and main benefit of the Like Kind exchange is that this law created a way for investors to leverage themselves into larger investments as their equity in their current properties grew over time.
For example, let’s say you bought a 4 unit property in North Park for $700,000 in 2009 post market crash. Fast forward to 2020 and you’ve now amassed a TON of equity in your current property. Your 4 unit property is now worth $1,500,000, and you have $1,000,000 worth of equity in your property.
You are now sitting on a bunch of, what us brokers and investors like to call, “lazy” or “dead” equity that is not working as hard for you as it should be.
The Investor now realizes this and now decides to sell their smaller 4 unit property in North Park, and looks to scale up into a bigger apartment building with more units.
The property sells for $1,500,000, and then the investor finds a 12 unit building in University Heights for $3,600,000 that he or she really likes and decides to close on it.
The investor now went from 4 units to 12 units in a similar submarket of San Diego with fantastic tenants, and those tenants will pay down much more principal than the 4 units he or she used to own.
A billionaire real estate investor once told me that the name of the game is “swap until you drop.”
The goal is to retire with as many units as possible.
Would you rather retire with a 50 unit apartment complex or a 4 unit apartment complex?
Some investors will get even more aggressive, and with that same $1,200,000 will buy in a lesser market like City Heights or El Cajon and buy up to 24 units or even more scale.
If you’re not from San Diego, University Heights and North Park are nice Class A- markets with a mid income, low maintenance tenant base.
While City Heights and El Cajon have a higher maintenance, low income tenant base.
So in summary, the first benefit of doing a 1031 exchange, is that allows for you to scale into more units, increase cashflow, increase your yearly principal pay down, and increase your tax shelter, because you are now depreciating a much more expensive building.
The Second benefit of a 1031 exchange is the flexibility that it gives an investor if he or she wants to move their money to a different location, or if the current property they bought is not performing how they expected it would.
If an investor owns a property in a Class C market and sick of dealing with the maintenance of the property, he or she may want to sell, and exchange into a Class A submarket, such as a property in Pacific Beach.
Or the other way around, an owner who owns in a trophy market, such as La Jolla, CA, might want more monthly cashflow and will make the move into a lower income market for a higher yield.
Also, if an investor bought an investment property that isn’t performing like how they want it to then he or she can elect to move the equity into another property.
For example, if a property isn’t cash flowing like the investor wanted it to, there is too much maintenance involved, or they have not gotten the appreciation, these are all motivating factors for someone who might elect to complete a like kind exchange.
The third benefit of a starker exchange is consolidation. Someone who wants to consolidate, for example 3 smaller properties, into one larger property that is less of a headache to the landlord is a reason to exchange.
The fourth benefit of completing an exchange is to separate the equity into a number of different properties. For example, if an investor has three children, and owns one large apartment building, he or she might sell that apartment building, and 1031 exchange into three smaller apartments for each heir to inherit after he or she passes.
Last, but not least, the fifth benefit of completing an exchange is to reduce property management headaches. Some investors who are sick of dealing apartments will look to reduce their workload and turn their income to something completely passive by buying a NNN Lease property, A DST (Delaware Statutory Trust), or a REIT (Real Estate Investment Trust).
The 1031 Exchange Guidelines
There are strict guidelines when it comes to successfully completing a 1031 exchange exchange. These are key rules that you must be aware of:
1) You Must Exchange Into a Like-Kind Property
You cannot sell your investment property to buy a primary residence. A Like Kind property simply means that you have to trade an investment property for an investment property.
You can’t sell your primary residence and exchange into an investment property or sell your investment property and put the earnings into the stock market or a business.
Examples of scenarios that would work are exchanging out of a single family home or condo that you do not live in and buying a four plex, exchanging an apartment building for a shopping center, or exchanging a commercial property for a vacation rental.
2) The Property Must be Classified as a Business Property
To reiterate what I briefly mentioned earlier: The properties you swap must both be considered business or investment property, not a primary residence for another.
3) The Property You Buy Must Be Greater or Equal Value
The property you buy into when you complete your 1031 exchange must be a greater or equal purchase price, as the property you sell in order to buy your up leg.
The upleg, aka the property you buy, MUST be equal or greater value of the property you just sold, aka your down leg.
4) You Must Take On the Same Amount of Debt or More
After you sell your property in order to exchange or swap into the property you buy, you must take on the same amount of debt or more debt that was on the property that you just sold.
For example, if you sell a million dollar property that you owed the bank $500,000 on, the property you buy you must take on $500,000 worth of debt or more.
5) You Will Be Taxed On Any Cash You Want To Put In Your Bank Account
If you take any cash out of the property that you sell, you must pay “boot,” which is defined as the amount of money you will have to pay capital gains taxes on.
So, if you sell a property and need $50,000 to pull out of it for personal or business reasons, you will get taxed accordingly on that $50,000 you pulled out of the property you just sold.
6) The 45 Day Identification Window and 180 Purchase Window
The property owner who sells his or her property has 45 calendar days to identify up to three properties, and must relay that information to their 1031 Exchange Accomodator.
The 45 day window starts after the close of escrow of the down leg property.
The 180 day window to close on at least one property starts after the close of escrow as well. According to the IRS guidelines, in order for an investor to successfully complete his or her exchange, he or she must close escrow within 180 days after closing on the down leg property.
7) The Funds Can Never Go Into Your Personal Bank Account
If the funds from the down leg(s) touch your personal bank account or your business bank account, the 1031 exchange has failed. The funds from the properties you have sold but be held by a trusted 1031 accommodator. A 1031 exchange accommodator is a qualified intermediary who helps facilitate your 1031 exchange transaction.
The accommodator should have the experience, expertise, and track record to assist you all the way through your 1031 Exchange transaction. Exeter 1031 and Investors 1031 Exchange are two reputable companies that I recommend to all of my clients.
A reputable Qualified Intermediary is critical in the structuring and completion of a successful 1031 Exchange transaction. They are authorized and required under Section 1.1031 of the Department of the Treasury Regulations and is the central component in a 1031 Exchange transaction.
Their main responsibility is to keep your funds safe in their account, coordinate with escrow on your timeframes, and help ensure you smoothly complete your exchange.
Why You Must Work With An Agent/Broker Who Understands 1031 Exchanges
It is extremely important to work with an agent or broker who understand all components of the 1031 exchange, because he or she will be able to advise you the most effectively, and will make sure you do not fail on your 1031 exchange. It is also critical to work with an expert who always has clients in exchanges because they will know how to properly negotiate the down leg properties and the up leg properties on your behalf.
For example, a competent broker would give you much more time to sell your down leg properties in order to give you more time to go shopping for properties that you would want to buy. I would bill in at least two 30 day extensions at the sole discretion of the seller if I was representing a seller trying to complete a 1031 exchange.
It is also important to notify and negotiate with potential sellers of the properties you as investor are looking to buy that you are indeed in an exchange. An exchange buyer is usually the strongest buyer in most scenarios, so this helps put your client ahead of other buyers competing for a property.
There are a lot of moving parts in an exchange, so if you have someone who only knows how to sell single family homes and do open houses, you’re not going to be in the best hands. You have to make sure you ask all of the right questions to a professional and know exactly what you are getting yourself into.
In conclusion, 1031 exchanges are one of the strongest wealth building strategies investors have used for many decades in order to grow their real estate portfolios. As long as you do your research, understand all of the basic rules, and work with a professional, you will 110% be able to successfully complete your exchange and move one step forward in your wealth building pathway.
I have personally helped a number of clients who have successfully and happily completed their exchange who I can put you in touch with, and are extremely glad they made that leap of faith. Once you do it once, it becomes easier and easier the next few times.
For more information on 1031 exchanges, feel free to shoot me an email at Jason@jasonleemultifamily.com or call me at 858-336-9688.