Last Updated: February 14, 2024

Summertime in Real Estate Means It’s ‘Sizzling’ Peak Season

Given both the hot housing market and low mortgage rates, there has been tremendous demand for buyers looking for homes.

Over the years, many of our clients have purchased real estate intending to generate passive income. What we often see is that their property has appreciated quite substantially between when they purchased the property to now. As a result, this oftentimes raises an issue regarding their internal rate of return. In other words, for the same amount of money/equity, real estate owners could be potentially increasing the money in their pocket on an annualized basis through a 1031 exchange.

What is a 1031 Exchange?

Property sold or transferred for gain is generally subject to taxation, which can add up quickly depending on appreciation, capital gains, and a variety of other factors. A 1031 exchange is a process authorized under Section 1031 of the Internal Revenue Code, also known as a tax-deferred exchange, allowing an individual to defer paying capital gains taxes on an investment property when it is sold, assuming you reinvest the proceeds from the sale of the investment property within a certain timeframe into a property and/or properties of like kind and equal or greater value. Doing this type of exchange allows your investment property to grow tax deferred. Keep in mind that your primary—and often, vacation—property is not eligible for this type of exchange. Property held primarily with the intent to sell, like developed land, is also not eligible for this type of exchange.

Other property types are excluded from 1031 exchange eligibility, including:

• Inventory or stocks in trade

• Stocks, bonds, or notes

• Other securities or debt

• Partnership interests

• Certificates of trust

The IRS requires a 1031 Exchange Qualified Intermediary to complete the process; this third party can provide further information on how exchanges work. After the intermediary purchases the new property, any remaining cash left over will be returned to you after 180 days; this is generally taxed as a capital gain.

Why would you sell your property?

Real estate owners look to sell their property/properties for a few reasons, but the most common are:

1. They want to tap into the equity in their investment.

2. They realize that their current property may not generate enough income; in other words, they are generating a low internal rate of return on their property.

Why would you consider a 1031 exchange?

1. Defer capital gains tax

2. Potential for a greater internal rate of return with a better-performing property

3. Diversification and/or consolidation

4. Reset the depreciation cycle, if needed

What is a “like-kind” exchange?

According to the IRS, “Both properties must be similar enough to qualify as ‘like-kind.’ Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”

A 1031 exchange can be a savvy investment move, but the process is complex and requires enlisting professional help. Find out if your property could be generating significantly more income and if a 1031 exchange is right for you by scheduling a 15-minute call with our team.

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