Can You Do a 1031 Exchange on an Investment Property?

As a property owner, you’re tasked with considering both present circumstances and future outcomes. How can you ensure that your rental or investment property is profitable, even when it’s time to sell? When it comes to rental properties and 1031 exchanges, there’s a wealth of information you may not know.

In our Ultimate Guide to Selling Rental Property, you’ll find a basic overview of why you’d want to sell your rental property and how you can get started. While timing plays a role in your decision, having realistic expectations and a working knowledge of tax rules is important.

In this post, you’ll learn more about the ins and outs of 1031 exchange properties.  Once you’re aware of the benefits, drawbacks, and personal considerations, you can make an informed decision based on your own financial situation and unique tax burden.

What is a 1031 Exchange Property?

A “1031 Exhange” refers to Section 1031 of the Internal Revenue Service (IRS) code in the United States. Section 1031 describes “Like-Kind Exchanges” that apply to the world of investment real estate. 

A like-kind exchange simply means that an owner is eligible to sell a property and invest the money back into a similar property. There are important rules and definitions to follow, including the fact that you must be recognizing a gain, rather than claiming a loss. Additionally, like-kind rules apply only to similar properties within the United States and are not eligible on international rental properties. 

For many investors, the most beneficial result of Section 1031 is the ability to defer taxes on capital gains. We’ll take a closer look at more of these tax and financial considerations later.

Can You Do a 1031 Exchange on a Rental Property?

In short, the answer to whether you can do a 1031 exchange on your rental property is yes! Section 1031 of the IRS code doesn’t include specific language for landlords. While that’s the case, this solution can be a saving grace for many investors who self-manage their properties. 

There are many reasons you might consider a 1031 rental property exchange. These reasons might include:

• A desire to expand or diversify your current holdings
• Recent availability of a more profitable or low-maintenance property
• Factors involving tax burdens that relate to property depreciation

Additionally, a 1031 or like-kind exchange may prove helpful if you’ve made a previous bad investment. In an ever-changing market, real estate valuation ebbs and flows. To an investor, the constant shifts can either be profitable or can significantly cut into individual assets.

Even if you were not the original purchaser or owner of a property, selling means that you are the one responsible for any capital gains taxes. This is an important consideration for rental property owners who typically do not keep primary residence in their managed properties.   

What are the Benefits and Downsides of 1031 Exchanges?

If you are a landlord or property owner, you should consider options from every angle. Occasionally, what sounds perfect in the short-term can prove disastrous down the line. As always, involving real estate and tax professionals can help you weigh the pros and cons.

Positive Consequences of Rental Properties and 1031 Exchange

• Accrued wealth: This option helps investors escape heavier taxes in the short-term, which may be possible indefinitely depending on other factors. This means that financial gains happen faster, with fewer immediate setbacks.

• Increased purchase power: This factor is a numbers game. Keeping more money in your pocket means that it could be possible to upgrade on quality and expand your current holdings.

• Tax free for life: According to the Real Estate CPA, deferred investment property taxes are erased upon a person’s death. While this should be discussed in-depth with an attorney, many real estate investors could see a 1031 exchange as a way to protect future family members from additional tax burdens. 

Negative Consequences of Rental Properties and 1031 Exchange

• Intense rules and regulations: If you opt for a 1031 deal, you should be aware of any ramifications to using a tax workaround. Playing by the rules and laws is paramount.

• Use of a qualified intermediary: Be prepared to pay an attorney or real estate professional to handle the legalities and paperwork. According to the law, you cannot handle this step on your own.

• Strict timelines: When you set the wheels in motion as an investor, you’re ultimately on the clock. There are set time periods for finding and buying new properties.

Should You Aim for a Paid-Off Rental Home?

Savvy real estate investors will understand and anticipate the continuous cycle of questions and discoveries that impact success. One of these vital questions involves whether to pay off the mortgage of a rental property in the first place. 

Before you proposition yourself for a 1031 like-kind exchange, you may consider how much (if any) you still owe on the original loan for the property. Do any of the following scenarios apply to you?

• You are losing money each month on the property and are in a negative cycle
• You expect that earned monthly rental income would be better than tax write-offs
• You are considering retirement and how to generate cash with a completed sale
• You have a higher interest rate on the loan than you do in rental profit margin

Before you make a decision, take a look at your goals for what you want to earn on the property in an ideal situation. Paying off a rental property mortgage may be contingent on several other factors, including where you stand financially with your primary residence.

Calculating Deferred Gain

As you consider rules for a 1031 exchange rental property, the math can get complicated quickly. There are several tools and calculators available for understanding your deferred gain on a real estate investment. Be prepared to provide extremely specific numbers and values to get the best estimate.

4 Ways You Can be Taxed

As you approach the time to sell, be prepared for taxes from all angles. There are 4 primary avenues through which taxes on gains may take place. These include:

• Recaptured depreciation in the property
• Federal capital gain tax based on taxable income thresholds
• A 3.8% tax on net investment income to accommodate Medicare surtax
• Any applicable state-level taxes (these can range from 0-10%)

For many real estate investors, high taxes are a driving factor in deciding to go the 1031 exchange route. Although taxes don’t always imply loss, hefty profit cuts change the overall results of a sale.

Anticipating Deferred Gain on Investment Properties

Put simply, capital gains are calculated by taking your basis and subtracting it from the sale price. A basis is composed of:

• Original payment amount for the property
• In addition to any home improvements or upgrades
• Minus relevant depreciation amounts

By understanding the above guidelines, you’ll be able to use an equation to determine the sum that is eligible for taxation. Keep in mind that using a 1031 exchange creates deferred capital gain. 

A 1031 exchange doesn’t eliminate the tax, but it does create a system in which investors can delay the tax while through a property trade-off. It’s important to mention that you could forfeit some notable write-offs by completing an exchange.

Simple calculations may be able to give you a preview of your expected deferred gain. While that’s the case, it’s still important to involve a professional who is well-versed in the mathematics of 1031 rental property exchanges. This ensures that you have the most accurate information possible. 

How to Execute a 1031 Exchange

Completing a 1031 exchange includes several critical steps. First, you need to research options and develop a plan for your own financial situation. Second, you need to decide whether selling a rental property at a given time is right for you. Only after these critical pieces are in place can you move forward with a crafting a 1031 deal.

To begin, contact a lawyer or legal representative who is well-versed in 1031 laws. You must appoint a Qualified Intermediary for the duration of the process. Once you appoint the intermediary, you’ll have a list of predetermined steps. These include:

• Creating a contract to sell your current rental property
• Exchanging the necessary documents to relinquish ownership of the old property
• Identifying a new property to purchase within the legal timeframes
• Signing necessary legal documentation to complete both sale and purchase processes
• Closing on the new property and informing your intermediary 

Ready to Explore Your 1031 Options?

Whether you’re a seasoned veteran or completely new to the world of real estate investing, planning and preparation is critical. When it comes to guidance and insight on 1031 exchanges, you simply can’t afford to navigate the complexities by yourself. 

Consult the professional team at Century 21 Northwest Realty for real estate investment and property management services today. Not only will you receive valuable education and insight on modern real estate trends, you’ll also receive practical advice for your unique situation. It’s never too late to get started on managing your investment options!

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