TL;DR: 1031 exchange is an awesome way to defer paying taxes. You should consider it for any real estate sale you’re making – even syndicates you might invest in. In the most likely scenario you’ll avoid paying any capital gains or depreciation recapture, and if you plan your estate properly, your heirs can avoid paying that entirely when they get a step up in basis. Calculating taxes owed (if any), and future depreciation you can expense is pretty easy, just read below and use the 1031 calculator provided!
The 1031 exchange is one of the great tax advantages available to real estate investors. In short, it allows you to buy and sell almost any type of investment property in the US without triggering any capital gains tax or depreciation recapture. You can do this as many times as you like, and if you play things right, when you pass on your properties through your estate, your heirs will get a stepped up basis that wipes out any previous capital gains and depreciation recapture. Huge!
This favorable tax deferral isn’t available for other assets like stocks, bonds, or private companies. When you sell one of those, the IRS will be waiting for their share of the profits, and there’s no way to defer that.
When researching the 1031 exchange though, there is a lot of noise. Confusing and misleading articles make it difficult to understand how it really works. The below summary (and interactive model!) is the simplest way I’ve been able to explain it to myself. I hope it will help clarify things for you as well!
How does a regular property sale work?
When you sell an investment property, the IRS typically wants two things from you: capital gains and depreciation recapture. Once they get paid, the rest is yours to do with as you please.
Capital gains are assessed on any profit you make from the sale of the property – that is, any amount over the price you paid for it. If you buy for $100K and sell for $130K (after fees, expenses, and improvements), the IRS will tax the $30K profit. The top capital gains tax rates will run anywhere from 23.8% in a no-tax state (20% Federal, 3.8% Obamacare) to 37.1% for someone in California (20% Federal, 3.8% Obamacare, 13.3% California).
Depreciation recapture is slightly different. During the time you own a property you can depreciate it’s value against earnings, thereby reducing your taxable income. This is another great tax advantage of real estate. But when you sell, if you receive more than the current basis value (price you paid, plus improvements, less depreciation), the IRS will tax anything in excess of that, up to the original purchase price (plus improvements), as depreciation recapture. Using the example above, assume the property purchased for $100K was depreciated by $20K over the life of the holding period so the basis value of the property was now $80K – in this case, the IRS would tax that $20K difference. Recapture rates will be taxed at your ordinary income rates, up to a max of 25% from the Federal government. So top rates could range from 28.8% (25% Federal, 3.8% Obamacare) to 42.1% for someone in California (25% Federal, 3.8% Obamacare, 13.3% California).
How does a 1031 exchange work?
With a 1031 exchange, you can defer paying those taxes. The general idea is that the government wants to promote liquidity in the real estate market, so they allow you to defer those tax payments as long as that money remains invested in US real estate in one form or another.
If you elect to do a 1031 exchange, you must identify a target property to purchase within 45 days of selling your previous property. You must close on that property within 180 days. There are also some stipulations around how funds are managed, so you’re well advised to consult a 1031 professional who can help manage the process for you – the key point is that you need a ‘qualified intermediary’ (QI) to handle the exchange of funds. The money from the deal can’t touch your hands or bank accounts at any time during the transaction or it will be deemed taxable. I’m not an expert in this field, but one person to contact about this would be Dave Foster from Exchange Resource Group. He comes highly recommended from the Bigger Pockets community.
If you adhere to all the stipulations of the 1031 exchange, you can defer the taxes referenced above. The exact amount deferred depends on how you reinvest your funds. If you want to avoid all taxes, you must do two things:
- Buy a property as, or more expensive, than what you sell
- Reinvest all proceeds you receive from the sale (after paying down your mortgage)
If you do that, then you will have no tax due. To get more technical, you want to make sure you have no taxable cash, and no taxable debt relief (emphasis mine):
Taxable Cash. Section 1031 states that any cash received, controlled or ‘touched’ by the investor during the exchange is taxable. Therefore, exchanges are set up so that the sale proceeds are transferred directly to a qualified intermediary (QI). The QI holds the funds until they are sent directly to the purchase closing. By using this structure and reinvesting all of the cash, the exchanger will have no taxable cash.
Taxable Debt Relief. Debt relief occurs when a mortgage or loan is paid off at the sale of the old property. For the IRS, this is considered taxable unless 1) the exchanger can replace the old debt with an equal or larger new loan OR 2) the exchanger increases the amount of cash invested in the new property by the amount of debt relief.
So you can see, if you reinvest all sale proceeds to purchase a property as or more expensive, then you will have no taxable cash (it is all reinvested), and no taxable debt relief, as you’ll need a mortgage or additional cash infusion that is as large or greater than what you had before.
But this is hard to talk about in concept. A few examples will go a long way.
A few examples…
Avoid all taxes
For this example, assume you have a property purchased for $100K, sold for $120K, with ~$29K of depreciation. This means you’ll have a $20K capital gain and $29K in depreciation recapture. After paying down an outstanding mortgage of $70K, you will have $50K in cash that needs to be reinvested.
One way to defer all taxes would be to purchase a $200K property, taking out a $150K mortgage and reinvesting the $50K cash. Doing this will defer a tax payment of ~$20K in this case (assuming the highest tax brackets for someone living in California):
Check out the 1031 calculator yourself, and create a copy if you want to play with your own assumptions!
Another acceptable outcome would be to make the same purchase, but instead only take out a $50K mortgage, and make up the difference with $100K in additional cash – in this case, you’ll also defer all taxes:
The point here is that you don’t need to use the same amount of mortgage debt on the new property you purchase. You just need to make sure the mortgage debt, plus any added cash exceeds the old debt amount.
Taking cash off the table
If instead you want to take cash off the table during the deal, you are going to pay for it. Let’s say you purchase the $200K property, but decide to use $160K in mortgage debt. This will reduce the cash reinvested in the deal down to $40K, meaning you took $10K of the $50K proceeds off the table. That $10K amount will trigger a taxable gain which (as I understand it) will get applied first against your depreciation recapture, getting taxed at a marginal rate of ~42% in this example ($4,210):
‘Buying down’ on property size
Lastly, if you decide you don’t want as much real estate exposure going forward, you might choose to reinvest in a smaller / lower value property. This will also cost you. Even if you decide to reinvest all your proceeds ($50K), investing in a smaller property will mean you need less debt, which will trigger the taxable debt relief. In this example, assume reinvestment in a $100K property with $50K cash coming from the previous deal. Only $50K in debt is needed, triggering $20K in taxable debt relief when compared to the previous $70K mortgage. That $20K would get applied first against the available depreciation recapture, resulting in a total tax of $8,420:
So you can see that if you want to take money off the table, the IRS will want their share. The safest bet is simply buying up and reinvesting all your proceeds from the previous deal.
What happens with future depreciation?
The last question worth addressing here, is a future facing question: How do you calculate depreciation on the new property you purchased through a 1031 exchange?
The simplest way to explain this is that you need to calculate depreciation for two things:
- The relinquished property you just sold
- The replacement property you just bought
If you do a 1031 properly, the IRS thinks of it as if you never sold the relinquished property – the tax basis and useful life from that property will carry over to the new property. Then, in addition to the depreciation you were taking on the relinquished property, you might be able to add more depreciation from the replacement property, assuming you ‘bought up’ or purchased more real estate than you sold.
So to use the first example above, if you buy up from a $120K sale to a $200K purchase, your depreciation will look like the following:
- Relinquished property depreciation – we said the original property was purchased for $100K and assuming 80% ($80K) of that is building value, results in $2,909 of depreciation per year (over 27.5 years). This building had been depreciated for 10 years already, so the owner can continue expensing $2,909 per year for the next 17.5 years. The relinquished property depreciation schedule can literally just carry over to the new property as is
- Replacement property depreciation – to determine the depreciation associated with the replacement property, the simplest approach (in this example) is to subtract the sale price of the relinquished property ($120K) from the purchase price of the replacement property ($200K), and that will be your incremental basis ($80K). Then, taking 80% of that amount ($64K) and dividing by 27.5 years will get you to incremental annual depreciation of $2,327
In total then, the $200K property can depreciate $5,236 per year for the next 17.5 years, and then only $2,327 thereafter for the remaining 10 years until all depreciable basis is used up.
Buying up, but taking money off the table
If you buy up, but take money off the table due to a refinancing (as per example above), you’ll end up paying down some of that deferred depreciation. If that happens, you’ll actually be able to add that amount you paid down back into the basis for the replacement property. In this case below, $10K in depreciation recapture was paid off, which means $10K can be added to the already stepped up basis for the replacement property, taking it from the original $80K to $90K. The result is that replacement property depreciation goes from $2,327 per year to $2,618.
If instead, you decided to ‘buy down’ with the replacement property, then in most cases, the calculation is further simplified. Because there is no ‘incremental’ value being added to the table, the replacement property will not generate any incremental depreciation. In most case, you’ll be able to simply continue depreciating the remaining basis value of the relinquished property at $2,909 per year until that expires in 17.5 years.
I have to admit, the only case where I’m not exactly certain what happens is when you really buy down – so much so that the value of the replacement property is less than the remaining basis value of the relinquished property.
In this scenario I could imagine two things:
- You don’t do a 1031… you just sell the relinquished property, pay your taxes, and then separately buy a new property and start depreciating from that new basis over 27.5 years
- The more complex approach would be to do a 1031 to try and preserve the higher depreciation amount available from the relinquished property.
The second scenario seems extremely remote, as you will end up triggering all the capital gain and depreciation recapture taxes… but in the event that you did do this, the best understanding I have is that the remaining basis from the relinquished property would be reduced by the amount of shortfall. Using the example below, if you bought a $60K property as your replacement from the $120K sale, you would trigger $29K of depreciation recapture, $20K of capital gains and pay ~$20K in taxes. The replacement property value is $60K, which is $11K less than the outstanding relinquished property basis value of $71K, so to adjust this you would reduce that basis down by the $11K. The impact on depreciation would be to reduce depreciable basis by 80% of that ($11K * 80% = $8,727). In the case below, the adjusted depreciable basis would then be $42,182 with a useful life of 17.5 years, resulting in annual depreciation of $2,410. It’s worth noting the $2,410 is higher than the comparable depreciation on a $60K property, which would be $1,745 per year ($60K * 80% building value / 27.5 years). But of course, the total depreciation taken would be $2,410 over 17.5 years (~$42K) vs. $1,745 over 27.5 years ($48K). This starts to get into time value of money arguments and other weird stuff. Suffice to say, I doubt you’ll have this problem, but if you do, those are some things to consider.
Summing things up
1031 exchange is a powerful way to defer taxes. I’m not a legal or tax specialist, so please consult a professional if you’re doing this and think you need help. That said, I hope the above scenarios and calculators will help you make sense of all the noise around 1031’s. They’re not actually that complicated, but I’m sure getting all the paperwork in the right places will be a pain, as are most things that involve heavy government oversight. But… it’s worth it, so keep good records and they’ll be worth their weight in gold.
All the best!