One of the favorite side gigs in our physician community is investing in real estate, as there are many tax benefits to investing in real estate, including the ability to gain equity in a valuable asset in a tax advantaged way. However, when you sell a rental property or other piece of commercial real estate - hopefully for a profit - you encounter capital gains taxes. The 1031 exchange is a tax strategy savvy way of deferring this capital gains tax and allowing you to re-deploy that money into another like investment. If estate planning is a consideration, it can also offer the ability to avoid paying capital gains taxes entirely when inherited by heirs. Below, we’ll cover the basics of what a 1031 exchange is, when you can do it, and how you can do it.
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What is the 1031 exchange?
The term 1031 exchange comes from the relevant section in the Internal Revenue Code, Section 1031. At the heart of it, it is a tax savvy way to sell an investment or business property and ‘exchange’ it for another investment or business property without having to pay capital gains taxes at that time. You can do the 1031 exchange as many times as you want and as frequently as you want as long as the rules are followed.
By doing the 1031 exchange, the IRS says that you are not actually cashing out of your investment but just changing its form, which allows it to continue to appreciate in value in a tax deferred manner.
You will eventually pay capital gains taxes when you decide to cash out, but currently in 2024, that means you will only pay taxes once, and at a long-term capital gains rate, which is generally very advantageous for high income earners like physicians versus short-term capital gains, which are treated as ordinary income and taxed at ordinary income tax brackets. In 2024, this means 15-20% for most physicians depending on your exact income.
1031 exchanges are also sometimes referred to as “like-kind” exchanges or “Starker exchanges.”
What rules do you need to know about the 1031 exchange?
Of course, these tax savvy moves are never without conditions. There are a few rules that need to be obeyed, the largest of which are:
The properties must be located in the United States.
The property that you buy must be “like kind” in the eyes of the IRS.
The proceeds from the sale can never touch your accounts. They have to be held in escrow by a third party until used to buy the next investment.
The 1031 exchange must be done within 6 months.
Generally speaking, only real property qualifies for 1031 exchanges, so investments such as franchise licenses do not currently qualify (they previously did prior to the Tax Cuts and Jobs Act of 2017). Similarly, exchanges of stock or partnerships do not qualify. Owning real estate as a tenant in common (TIC) does qualify.
There are also some more complicated rules, which you should talk about with an experienced real estate accountant or a 1031 exchange company to see how they apply to the properties you’re trying to exchange.
For example, personal homes and vacation homes have a different set of rules and would not qualify unless they are also being used for rental properties before being sold (check the details). Similarly, if you have claimed depreciation on a property and want to swap it out for a real estate investment that doesn’t have a building (for example, investing in land), you will have to recapture the depreciation as ordinary income.
What does ‘like-kind’ mean for the purposes of a 1031 exchange?
This is somewhat subjective, but essentially you can swap out one commercial property for another or a real estate long term rental property for another. Generally speaking, most commercial investment real estate properties identify. Other things can qualify, but the nuances get trickier. You’ll want to work with an experienced operator to determine whether or not you fall within the rules.
What is the timeline in which you have to complete a 1031 exchange?
This is where it gets tricky. You have a set amount of time in which you have to sell the first property and buy the next property while the 3rd party company holds the money in between.
There are two rules that are key, and your transaction must meet both of these.
45 day rule: The first is that you must designate the replacement property within 45 days of the sale of the property to the third party holding the proceeds of the first sale. You are allowed to designate three potential properties but must ultimately close on one of them (there is a caveat where you can designate more than three if they meet certain criteria).
180 day rule: You must close on the second property within 180 days of the sale of the old property (not within 180 days of designating it).
What is the reverse 1031 exchange?
You can also buy the new property before the first one is sold if you transfer the new property to an exchange accommodation titleholder. The same time windows apply.
What happens if the new property is worth less than the old property?
If you have cash left over after the exchange has been completed, the third party will pay it back to you once the 180 day period is done, but you will pay taxes on that portion, usually as capital gains.
How can you avoid paying capital gains into perpetuity with the 1031 exchange through a step up in basis when doing your estate planning?
If you eventually stop trading the properties and take the proceeds, you will trigger the capital gains being owed. However, if you pass away while still owning the property, your heirs don’t have to pay that tax. They will inherit it with a step up in basis, thus avoiding ever paying capital gains taxes on the appreciation of the amount invested.
What are the reporting requirements for a 1031 exchange?
You will notify the IRS via a completed and submitted Form 8824 as part of your tax return that you file for the year the exchange occurred. It will have all the characteristics of the properties that were traded and relevant dates, as well as the adjusted basis. This should be done under the consultation of an accountant experienced in real estate, as the penalties are large otherwise.
Conclusion
If you're interested in real estate investing as part of your path to financial independence, 1031 exchanges are a powerful way to further leverage the tax benefits of real estate investing. There are, however, several rules that you need to follow to ensure that you don't get caught in a complicated tax mess with capital gains. As mentioned above, we highly recommend working with a seasoned professional well versed in real estate investing and 1031 exchanges.
Additional real estate investing resources for physicians
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