You may have gotten your feet wet with fixing and flipping real estate. There are few things more exciting than being part of a significant property transformation and watching your profits grow. If you’ve sold a flip before, you know there is a significant payout to the IRS under the name Capital Gains Tax that sneaks in and takes quite a chunk of your earnings. While the profit (hopefully) makes that tax pill easier to swallow, did you know there is a way to defer the taxes associated with selling a property?
It’s called a 1031 exchange. As part of tax code 1031, you can take a long-term investment property, sell it, and purchase up to three more properties without paying taxes on the sale. As with most things tax-related, many wonder what the catch is, and here it is:
The IRS knows if they allow you to use the entire profit gained from the sale of one investment property to purchase more properties, you will eventually sell those properties as well, and they can grab an even more substantial amount in the future. It’s pretty tricky, but it really benefits both sides. In this article, we will teach you how to create and increase your real estate portfolio with a 1031 exchange.
It is crucial to note at this point that you can only use a 1031 exchange with an investment property. You can’t complete a 1031 exchange with the sale of the single-family home that you have been living in consistently for the last twelve years.
You can, however, buy a multi-family home, fix it up while living in one unit, and rent out the rest of the units. In this instance, your primary dwelling also happens to be an investment property. In that scenario, the property may be eligible for a 1031 exchange.
There is also another loophole to the rule: if you buy a single family home, own it for five years, live in it for a couple years, and then rent it out, it can be considered an investment property. You can then sell that investment property and complete a 1031 exchange with it.
Before you purchase any home or investment property with the intent to 1031 exchange it in the future, you want to make sure it’s a good investment. Talking with realtors in your area that deal specifically in investment properties is a good start.
What to Look For in an Investment Property:
There are quite a few ways you can gauge if the property you are looking into will be a good investment. If it’s your starter investment property, it most likely will not be a commercial property so we will focus on residential.
1) Location, Location, Location!
Chances are you aren’t going to want to invest in your own backyard. You want to find an area that has a high rental yield and is growing. If you are going to rent out your property, you need to make sure there is a demand for that type of rental. Compare several areas and even several states. Periodically, some real estate companies will publish articles about the best places to invest in based on the numbers and data they have at hand. It is a good idea to look into those areas and investigate further.
It’s said that the market recycles about every seven years. Knowing this, you’ll want to take a look at as much data on the area as you can to notice any peaks and valleys in the market. You want a location that stays pretty consistent rent-wise and population-wise. You especially want to run in the opposite direction if you notice a pattern of really high highs and low lows, as those investments typically are riskier than others.
3) Maximum Gain
Remember, you are purchasing a property to sell in a few years. You want as much capital in that property as you can get when you go to sell, so you can spread your investment even further. How do you find such a venture? You find homes that already have some equity them in after the purchase price. To do this, you could go through public records and locate a property where the owner has been having trouble keeping renters in it or paying their bills. You can write a letter to them inquiring if they would be willing to sell. If you buy a house that is not yet listed, you may have some room to negotiate a price that would be mutually beneficial.
Phase Two: Increasing Your Portfolio
Once you have your property and hold onto it for a few years, you should be able to use it in a 1031 exchange. To do this, you can choose up to three other properties (in most cases) to put the gains down on. The catch is that the property or properties combined purchase price must be equal to or higher than the profit you made from selling your first property.
For example: Let’s say you sold your rental property and made $90,000 on it. You then take the money and put $30,000 down on three other properties, each purchased for $150,000. You could not purchase one property for $60,000 and pocket the remaining $30,000.
An increase in portfolio doesn’t have to be in number only, however. You may exchange a small house in a shabby neighborhood for several units in a lovely part of town. While there are rules and caveats to each investment, the possibilities are really endless with 1031 exchanges.
As always, you want to speak to a real estate agent who has experience working with 1031 exchanges. There are specific paperwork and protocols to follow, and DIY-ing it has is perks in many places, but a 1031 exchange isn’t the place or the time to learn something new on your own. Find a real estate agent you can trust, because once you start using 1031 exchanges, there’s no limit to how large your portfolio can grow.
Andrew Schmeerbauch is the Content Director at Clever Real Estate and an active real estate investor in St. Louis, looking for financial freedom and passive income from multifamily investment properties.