The 1031 Exchange
Rolling sales proceeds from one property into another…
If you don’t need the cash today, you can defer your capital gains (and depreciation recapture) tax by rolling the entire sales proceeds from the property you sell, into another, usually larger, property. This is called a 1031 exchange.
For example, you purchase a property in 2012 for $250,000, by 2019 the property appreciates to $400,000 and you decide to sell. The capital gain from that sale is $150,000, and roughly $22,500 tax will have to be paid on that gain. If you didn’t have to pay $22,500 in tax, you would have an additional $90,000 in purchasing power to buy your next property. This assumes you use a leverage with a standard 75% Loan to Value ratio.
To properly complete a 1031 exchange you must:
• Identify up to 3 replacement properties within 45 from the date of sale
• Take ownership of the new property within 180 days of sale
The upside of doing a 1031 Exchange is you defer the capital gains tax and purchase a larger property. You can even use a Delaware Statutory Trust (DST) or TIC structure to receive fractional ownership of a much larger property if you’re burned out from managing properties yourself.
On the downside, 1031 exchanges can sometimes be difficult to execute and leaves you with a reduced basis in the replacement property, which will lead to increased capital gains down the line. And of course, this won’t help if you need the cash or are trying to exit real estate altogether.