What Is This "1031" Thing, Anyway?

Recently we've had several clients tell us that they've been advised by friends or colleagues to look into a 1031 Exchange to avoid paying capital gains. 

Funny thing is… a lot of the time a 1031 doesn't apply in their situation. 

On the other hand, we have clients that could DEFINITELY benefit from a 1031 exchange, but might not know to ask about it until it's too late in the decision-making process. 

So, as always, we're here to fill in some blanks and bust some myths.** 

Why would you NOT need to consider a 1031 Exchange? 

1. You don't have capital gains. 

Might seem obvious, but if you aren't making money on the sale, you don't need to avoid taxes. If you're selling for the same amount you paid (or less), you don't need a 1031. Also if you're selling your primary residence remember that unmarried people are already allowed $250k in gains that are capital gains exempt (whoo hoo, best tax law ever!). That's $500k for married couples. 

2. You're a homeowner selling your current primary residence.

1031 Exchanges are for investment properties specifically, so unless you are considering turning your primary residence into a rental, you probably don't qualify for a 1031 Exchange. 

3. You want to "cash out".

If you're in need of all of the proceeds from the sale of your property, a 1031 Exchange probably doesn't make sense. A 1031 Exchange only works if you are reinvesting the funds within a short window. 

4. You're selling a rental property that WAS your primary residence. 

This one sneaks up on people! If you have a rental property that used to be your primary residence, paying attention to the capital gains time windows is critical for preserving your possible tax exemptions. Let's say you lived in your San Francisco condo for 3 years before moving out 2 years ago renting it out. Now the tenant has moved and it's time to sell. You should still qualify for your primary residence capital gains exemption up to $250k for unmarried and $500k for married couples. So depending on the amount of your gains, you might not need a 1031 exchange to avoid that tax bill. 

What Is a 1031 Exchange?

Simply put, it’s a provision in the U.S. tax code (Section 1031, to be exact) that allows you to sell an investment property and defer paying capital gains taxes on the sale, as long as you reinvest the proceeds into a “like-kind” property.

Now, “like-kind” doesn’t mean the properties have to be exactly the same (you don’t have to exchange a condo for another condo, for example). It just means the properties must both be used for investment or business purposes. So, you could exchange a rental house for a commercial building or a plot of land for a shopping center—provided that the deal follows all the proper guidelines.**

The magic here is that you can defer paying the capital gains taxes that would typically be triggered when you sell a property. This lets you reinvest your profits without losing a significant portion to the IRS. Who wouldn’t want to kick the tax can down the road, right?

Why Is This So Powerful?

The power of a 1031 exchange lies in its ability to defer taxes indefinitely. That means, as long as you continue to roll your gains into new properties, you don’t have to pay taxes on the sale until you finally cash out. In the meantime, your investment keeps growing, allowing you to accumulate more wealth with fewer tax hurdles.

Let’s put it this way: if you sell a property and make a $200,000 profit, you’d typically owe capital gains taxes on that amount. In California, depending on your income bracket, you could be looking at a 30-40% tax hit on that profit. Ouch! But with a 1031 exchange, you don’t have to pay those taxes right away. Instead, you can use the entire $200,000 to invest in a new property. That’s a significant advantage when building a real estate portfolio.

Who Benefits from a 1031 Exchange?

1. Real Estate Investors: If you’ve been buying and holding rental properties in California, a 1031 exchange could be a goldmine for deferring taxes as you upgrade your portfolio. Perhaps you own a single-family rental in San Francisco, and you want to swap them for a multi-unit apartment building in Sacramento. A 1031 exchange allows you to do that without immediately having to pay capital gains taxes on the profit you made from the sale of your San Francisco property.

2. Property Owners in High-Price Markets: California is known for its sky-high property values, especially in cities like San Francisco, Los Angeles, and San Diego. If you’ve owned a property in one of these markets for a while, you’ve likely seen its value appreciate significantly. A 1031 exchange gives you the opportunity to sell at a high price and reinvest in another property, keeping all the equity working for you without getting dinged by taxes.

3. Business Owners: If you own a commercial property and want to sell it to reinvest in a different type of property, a 1031 exchange can also be useful. Maybe you have a small office building in Silicon Valley that’s appreciated, and you want to exchange it for a retail property in Santa Monica. Again, as long as both properties are for business or investment purposes, the exchange works.

If you fall into one of these categories, a 1031 exchange is worth exploring.

The Rules: What You Need to Know**

1. Like-Kind Property: The property you’re selling and the property you’re purchasing must be “like-kind.” As mentioned earlier, this doesn’t mean identical properties; it just means that they must both be held for investment or business purposes. For instance, you can swap a rental condo for an office building or land for a warehouse.

2. 45-Day Identification Period: After you sell your property, you have 45 days to identify potential replacement properties. This is crucial because if you fail to identify the new property within this time frame, you’ll forfeit the tax-deferred treatment.

3. 180-Day Closing Period: Once you’ve identified a replacement property, you have 180 days from the sale of your original property to close on the new one. This timeline can sometimes be tight, so it’s important to have everything lined up ahead of time.

4. Qualified Intermediary: You cannot touch the sale proceeds yourself. A “qualified intermediary” (QI) must hold the money from the sale until you complete the purchase of the replacement property. This ensures that you don’t violate the IRS’s rules regarding control over the funds. We can provide recommendations for some great ones. Hit us up! 

5. Equal or Greater Value: To maximize your tax deferral, the value of the replacement property should be equal to or greater than the property you sold. If the replacement property is of lesser value, you may be subject to “boot” (taxable proceeds) on the difference.

What Can You Buy in a 1031 Exchange?

Here’s the fun part: what types of properties can you buy in a 1031 exchange? The short answer is: quite a lot! As long as the properties are used for business or investment purposes, you have quite a bit of flexibility.

You might consider rental properties, raw land, commercial properties, or even shopping centers and industrial properties. For those who really want to wash their hands of managing actual real estate, there are also more outside-the-box instruments like Delaware Statutory Trusts that allow investors to hold a fractional interest in a trust's holdings, while a trustee manages everything. 

A Simple Example

Imagine you’ve owned a duplex in San Francisco for 15 years, and its value has increased dramatically. You originally bought it for $500,000, but now it’s worth $1.5 million. (yay) If you were to sell it without a 1031 exchange, you’d owe capital gains tax on the (approx) $1 million profit, which could amount to $300,000 or more, depending on your tax rate.**

Or, instead of selling and paying taxes, you decide to use a 1031 exchange to sell the duplex and buy a 10-unit apartment building in Sonoma for $1.5 million. By following all the rules, you defer paying taxes on that +/-. $1 million gain. You now have a larger, more lucrative property generating income for you—and you deferred the taxes on your original profit!

Conclusion: Is a 1031 Exchange Right for You?

A 1031 exchange can be a fantastic way to keep building your real estate empire without handing a large chunk of your profits over to the IRS. And when it comes to the tax climate in California, who wouldn’t want to defer a little tax and build a more robust investment portfolio?

When considering whether a 1031 exchange could be right for you, start strategizing your next property move early, and involve your advisors, including your Realtors (ahem, that's us!), your financial advisor, and your CPA. Happy investing!

** We are not tax professionals or attorneys! Nothing in this article should be construed as tax advice. It is 100% essential to check with your tax professional before making any decisions related to 1031 or other tax laws. 

For sophisticated tax advice, especially in the real estate realm, we highly recommend:

Shaan Afridi, CPA

[email protected]

www.orangecountytaxplanning.com

Brought to you by the top real estate agents at Pacific Edge Real Estate Group