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Woman working on a 1031 exchangeWhen investors want to diversify their portfolios, they often consider real estate. But if you’re interested in real property, you need to know the ins and outs of purchasing and selling. One method many investors rely on is called a 1031 exchange. By following the rules for this type of exchange, investors can defer their capital gains tax while working towards better and bigger properties. Understanding how a 1031 exchange works is crucial to its success, though. Here are a few example scenarios to help you get familiar with it.

Taxes and real estate can get confusing. Consider working with a financial advisor as you work to make sure your real estate investing is as tax efficient as possible.

What Is a 1031 Exchange?

A 1031 exchange is a tax-deferment strategy often used by real estate investors. In this process, the owner of an investment property (or multiple) sells their original property and buys a like-kind property as a replacement. By following the IRS’s rules during this procedure, they defer capital gains tax.

A like-kind property exchange doesn’t mean you need to swap the exact same type of building. They also don’t need to share the same quality, only their character or class. For instance, a vacant lot is like-kind with a real property improved with a rental building. You can tailor your exchange to meet your goals and needs as long as it meets the requirements laid out in Section 1031. However, investors should note that real estate within the U.S. cannot be like-kind with any property outside the country.

The process also requires the use of certain channels. Namely, you need an exchange facilitator. According to the IRS, this is a “qualified intermediary, transferee, escrow holder, trustee or other person that holds exchange funds for you in a deferred exchange” under the applicable terms.

There are also four different types of 1031 exchanges: simultaneous exchange, delayed 1031 exchange, reverse exchange and improvement exchange.

1031 Exchange Examples

A 1031 exchange requires you to fulfill two crucial rules.

First, there is a minimum value requirement. The new property, or properties, must have a purchase price equal to or more than the amount you sold your real estate for. So, if you sell your property for $600,000, then you must buy a replacement property worth at least that much.

The second requirement applies to financing. Essentially, anyone with a loan on their original property must carry the same amount of debt or more with the replacement property.

Here are some examples to illustrate how a 1031 exchange works.

Example 1: The Basics

Tax payer preparing to pay capital gains taxSuppose you are a real estate investor. You choose to sell your current property with a $150,000 mortgage on it. It sells for $650,000. If you want to meet the conditions for a 1031 exchange, you much purchase a replacement property for at least $650,000. In addition, you need to borrow a minimum of $150,000 to pay for it.

Sounds straightforward, right? But we all know the real world is a little more complicated than this. The following examples show you how the situation may change.

Example 2: Higher Value Replacement

It’s unlikely you’ll find a replacement selling for exactly the same amount as your original property. With that in mind, let’s say you sell your property with a $300,000 mortgage on it for $500,000.

While searching for a replacement, you find a property you want to buy. But it’s valued at $700,000. In that case, you contribute $200,000 out of pocket and purchase the replacement with a $300,000 loan and $400,000 of cash. Like this, you can still defer taxes since you satisfy the two basic requirements.

Example 3: Increased Leverage

One concept in real estate is known as leveraging. Basically, it means using debt, such as a loan, to buy an asset, like property. Investors can increase their leverage using a 1031 exchange, allowing them to invest in a higher-value property. As a result, they can not only improve their cash flow but multiply the rate they build equity at.

So, suppose you sell one of your first investment properties for $500,000. You still owed $100,000 on the mortgage at the moment of sale. But you want to set your sights higher. As a result, you move to purchase a property that costs $1 million.

You use the total profit from the sale at $400,000 and take out a new loan worth $600,000. With this, you meet the 1031 exchange requirements.

Example 4: Partial 1031 Exchange

It’s actually possible to sell an investment property and satisfy the 1031 exchange rules without using all of your sale proceeds. This is called a partial exchange. However, buying a replacement for a lower cost than the original property’s sale price or taking out less financing will result in taxes.

For instance, we’ll say you sell your original property for $650,000. It had a $200,000 mortgage leftover. You then purchase a property for $500,000 but still take out $200,000 for the loan. The $150,000 in profit unused becomes taxable income.

Essentially, you still defer taxes on the better part of the sale from the first property. But the money that you didn’t put into the replacement still faces capital gains tax or depreciation recapture.

The Takeaway

Aerial view of a plot of real estate

A 1031 exchange comes with a few advantages, including deferring capital gains tax, expanding your portfolio and more control during the sale of property. And the way you go about your exchange can vary depending on your goals and needs. Before pursuing a 1031 exchange, research the requirements in depth and consider speaking to a financial advisor. Similarly, any investors interested in real estate should do the same. A financial professional can guide you through the rules and consequences which could impact your future investments.

Tips for Investing 

  • Many investors use real estate, whether through REITs or physical property, to diversify their portfolios. However, you may want guidance before you change your investing strategy. If so, consider speaking with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • You may already be making strides to reach your retirement savings goals, complete with a strategized investment portfolio. Perhaps you even have an emergency fund safety cushion prepared for sudden changes. But maybe it’s time to diversify, earn greater returns or a passive income. In that case, real estate might be your golden ticket. Just research the historical trends and expected performance beforehand.
  • Most advisors recommend having a diversified portfolio. Adding real estate can offer additional diversification and non-correlated assets to your portfolio. Our asset allocation calculator can help you determine how much of your portfolio to invest in real estate.

Photo credit: ©iStock.com/PeopleImages, ©iStock.com/designer491, ©iStock.com/RonFullHD

Ashley Kilroy Ashley Chorpenning is an experienced financial writer currently serving as an investment and insurance expert at SmartAsset. In addition to being a contributing writer at SmartAsset, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.
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