1031 Exchange: A Real Estate Investor’s Safe Harbor from Capital Gains Taxes

Thanks to factors such as low interest rates and baby boomers’ strong demand for second homes, the real estate market has never been hotter. Favorable tax treatment for investment property is also fueling a record-breaking boom in second homes, rental houses and commercial purchases. With the right information, property owners can completely eliminate capital gains tax liability.

John Mangham of Starker Services, Inc., is an expert on what is called a “1031 Exchange.” He teaches seminars around the country and always begins by putting his students’ minds at ease. This stuff isn’t complicated, he assures them: “It’s a tax thing . . . and we’re going to save some money.” Never technical, Mangham goes on to describe how easy it is to avoid a significant tax bill after the sale of investment property.

Primary Residence Vs. Investment
If you sell your primary residence, you can exclude up to $250,000 per person ($500,000 for a married couple) from tax liability. That means, if you make a profit of $100,000 on the sale of your home, you’re in the clear tax-wise.

However, if you sell a second home or other investment property, the federal government requires that you pay 15 percent capital gains tax on the profit of that sale. In addition, you might be responsible for taxes on the depreciation of the property that you’ve claimed on your income taxes over the years. (In some states, additional state taxes may also apply).

What constitutes “investment property?” Any number of real estate products qualify, Mangham says, including a rental house, a condo at the beach or even a self-storage facility, as long as it is “real property” – meaning land and all that is attached to land – and the property is not your primary residence. Boats, motorhomes, time shares, and recreational vehicles do not count as real property under the tax code.

The tax liability can be significant on investment property. Mangham cites an example when the tax bill on a $150,000 rental house was upwards of $30,000. “Wouldn’t you rather put that money to work in the market rather than sending it to Washington?” Mangham asks.

1031 Exchange Explained
To avoid that tax liability, you can complete a “1031 exchange,” also known as a “like-kind exchange” or a “Starker exchange.” 1031 is the section number of the tax code that allows property owners to avoid taxes on the sale of investment property, provided that property is exchanged for property of an equal or greater value. “By ‘exchange’ we don’t mean that you take a picture of your Atlanta rental house down to the beach and find someone who will trade with you,” Mangham laughs.

Instead, you sell your Atlanta rental house, and then you have 45 days to identify a replacement property of equal or greater value. Homeowners submit letters of intent to “qualified intermediaries,” like Mangham’s company, where they list the three properties from which they plan to choose. Within 180 days, you have to close on the second property, he says, and that property must come from those listed on your letter of intent, Mangham insists, in order for the exchange to be successful.

“The biggest challenge in today’s market,” Mangham says, “is finding suitable replacement property in that 45 day period. It’s such a fast-moving market that we’re in.” One strategy that he recommends is finding “pre-construction properties,” such as condos that are a couple of years from completion. Most will take reservations – and possibly even sell out – long before ground has been broken.

If you place a deposit on a pre-construction unit, “you’ve already identified the property you plan to buy,” Mangham points out. After you sell your initial property, you then have 180 days to close on your pre-construction condo.

The exchange doesn’t have to be a one-residence-for-one-residence exchange either, Mangham says. Depending upon the amount of your initial sale and the cost of the property you plan to purchase, you might find yourself exchanging one $1million beach condo for seven $150,000 rental houses. Or you might sell a $150,000 rental house and get together with ten friends and purchase a beach condo worth $1.5 million, making you a 1/10 owner of the condo.

Most “fractional ownerships” – which is how this 1/10 share is identified – qualify for 1031 exchanges as well, Mangham says: “You just have to spend the cash from the sale, and it must be used for the purchase of ‘like’ property held for investment.”

Finalizing the Deal
The qualified intermediary files all the appropriate paperwork, from the first letter of intent to the final document that accompanies your tax return. Generally speaking, these companies charge less than $1,000 to complete a one-to-one exchange. Mangham says that his company provides free initial consultations to property owners who call their offices.

Once you’ve exchanged a rental house for a beach condo, you have to be able to prove that the property was purchased for investment. “That’s easy,” says Mangham. “You just rent it out.” Most condos have rental programs that allow the management to handle the details of the leasing for you. There are also several websites that make it easy for owners to rent their properties themselves.

The condo maintains its status as “investment property,” so long as your personal use is minimal. Approximately two weeks of personal use is considered acceptable. Time spent in maintenance and supervision of the property is not considered personal use time, though, Mangham says.

Let’s imagine that you’ve purchased that dream condo on the beach and have decided to rent it out as an investment property. Eventually, you decide to drive down and check on the condo, as a good landlord should. You pack the kids up on Saturday and drive down. Then on Sunday, you walk around the property and assess the state of the space: you notice a wall that needs patching, that the blinds need to be replaced, and the cabinets need to be painted. On Monday you go to Home Depot and purchases materials, and then on Tuesday you get started on the work; maybe the kids even give you a hand.

On Wednesday you schedule an interview with the management company to set the rent rates for the year, while Thursday is set aside for shopping up and down the road to check comparable rent rates on other properties. All of this is working on your investment property, and does not count as personal use. So finally on Friday, you take a day off, before driving home on Saturday. “In this scenario,” says Mangham, “You’ve only had one personal use day, even though you’ve been at the beach for a week.”

Long-term Planning
The big message, says Mangham, is forward thinking. As long as you keep your investment in the real estate and continue exchanging, you can continue to build your equity for the rest of your life and never pay taxes on that property. “If you then one day leave the property to your heirs,” Mangham says, “capital gains taxes will never be paid.”

Mangham believes he teaches his students and clients how to live a true American dream. “A savvy 1031 exchange investor thinks about what he needs in the five-year horizon,” he says. Eventually, a condo at the beach may not be as attractive as a rental property that can support your children’s or grandchildren’s college tuition.

“People are even using 1031 to do retirement planning,” Mangham says. It’s possible to continue trading up, as your properties gain value, and eventually exchange for the kinds of rental properties that will secure your comfortable retirement. And eventually, when you do retire, you can even move into your beach condo and convert it to your primary residence.

“The ultimate strategy is a multi-generational planning tool,” Mangham says. “The assets have been thought through for the longer term . . . without ever making a stop to pay the IRS.”

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