Did you know that there is a legal way to defer capital gain taxes on your investment properties? It’s called a 1031 Exchange, or a Like-Kind Exchange, and it’s a federal tax code recognized by all states, including Colorado. Let’s take a look at the law and how 1031 Exchanges can benefit real estate investors.
1031 Exchange Law Explained
IRC § 1031 (a)(1) states:
"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."
In other words, this law allows an investor to sell a property and reinvest the proceeds in a new property to defer capital gain tax. This allows your investment to grow tax-deferred. Since there is no limit to how many times you can do a 1031 Exchange, you can continue rolling over the gain from one real estate investment to another, to another, and you won’t pay taxes until you sell many years later. Therefore, you’ll be taxed at a long-term capital gains rate which is much lower than a short-term capital gains rate.
Consider this example:
Investor X purchased his investment property for $700,000. He recently sold his property for $1,000,000.
Investor X has a $300,000 capital gain after selling his investment property. That means that Investor X will owe about $65,000 in capital gain taxes.
Investor X now has only $235,000 to invest in another property.
Assuming a 25% down payment and a 75% loan-to-value ratio, Investor X will be able to purchase a $940,000 property.
However, if Investor X uses a 1031 Exchange instead he would be able to invest the entire $300,000 into the new property. Assuming the same down payment and loan-to-value ratios, this means Investor X could purchase a property for $1.2 million.
What Properties Qualify for a 1031 Exchange?
The 1031 provision is only for investment properties or business properties; you cannot exchange your residence, however, the rules may apply to a former residence in certain instances.
Another provision under Section 1031 is that the properties exchanged must be considered “like-kind.” This rule is pretty liberal and probably doesn’t mean what you think it means. For instance, you could exchange an apartment building for land. Different assets can be exchanged as long as they qualify.
Here’s a look at all of the different kinds of properties that qualify for a 1031 Exchange:
Exchanging raw land or farmland for improved real estate
Exchanging oil and gas royalties for a ranch
Exchanging fee simple interest in real estate for a tenant-in-common interest in real estate
Exchanging residential, commercial, industrial, or retail rental properties for any other real estate
Exchanging a condo for an apartment building
Next are examples of properties that do not qualify under Section 1031:
Property held primarily for sale
Securities
Stocks, bonds, or notes
Certificates of trust or beneficial interests
Interests in a partnership
Choses in action (rights to receive money or other property by judicial proceeding)
Foreign real property for U.S. real property
Goodwill of one business for the goodwill of another business
If you’ve invested in some kind of real property in the U.S. you can usually apply the 1031 Exchange rules to another piece of real property in the U.S.
Different Forms of Like-Kind Exchanges
There are two kinds of 1031 Exchanges. In a simultaneous exchange, the two properties are exchanged on the same day. In a deferred exchange, the investor has 45 days to designate a replacement property and 180 days to finalize the exchange after the initial sale takes place.
Changes to 1031 Rules
The rules surrounding 1031 Exchanges are a moving target. The most recent change came about in December 2017 with the passage of the Tax Cuts and Jobs Act. Essentially, this new law makes it so only real estate qualifies for 1031 exchanges. Before the TCJA passing, some personal property like franchise licenses, aircraft, and equipment could quality as well.
The Bottom Line
1031 Exchanges are a great way for savvy real estate investors to build wealth. Regardless of whether you’re a new or seasoned investor, it’s always important to review the current qualifications and stipulations of 1031 Exchanges so you can make sure you understand the complexities. It’s an even better idea to consult with a qualified financial advisor to ensure your exchange is the most strategic option for your long-term goals.
Finally, if you’re looking for a rental cabin, farmland, or a ranch for sale in Colorado to add to your investment portfolio, you’ve come to the right place. Drop me a line for more information about your investment properties for sale on the Western Slope.