There is a powerful tax-deferral strategy used by many successful businessmen and investors that can allow you to easily side-step real estate taxes and keep more cash in your pocket in the process. At the same time, you get to keep real estate assets as a key part of your diversified portfolio.

If that sounds too good to be true, it isn’t. In fact, this tax-saving strategy has long been permitted under the IRS code. It’s called IRS Code Section 1031, or more affectionately know as a 1031 Exchange!

Simply said, a 1031 Exchange allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long as you are willing to purchase another property of “like-kind” with the profit earned by the sale of your original property.

For example, let’s say you’re invested in low-income rental properties that are high-maintenance and you want to eliminate the headaches. You could exchange the high-maintenance rental property for a low-maintenance duplex without needing to pay a significant amount of taxes.

Or perhaps you want to move your real estate investments from one location, say New York, to another, like Florida, without the IRS and state taxing authorities getting their hands into your pocket for capital gains tax. The 1031 exchange makes this possible.

Depreciation Recapture Saves You Money and Boosts Your Cash Flow

Whenever you sell an investment property, you are on the hook to pay capital gains tax. And if your property is worth significantly more today than when you purchased it, you can save big money and increase your cash flow, by understanding the key concept of depreciation, which is the real hidden benefit of a 1031 exchange.

Quite simply, depreciation is the percentage of the cost of your property that is written off every year for accounting purposes due to the effects of normal wear and tear. When you sell that property, capital gains taxes are calculated based on the property’s net-adjusted cost basis, which is the property’s original purchase price, plus capital improvements, minus the accumulated depreciation.

If you’ve owned the property for a long period of time, you could be talking about millions of dollars in accumulated depreciation. And if the property sells for a lot more than its depreciated value, you have to recapture the depreciation, which is included as taxable income from the sale of real estate.

That’s where a 1031 exchange can be so valuable, to avoid the large increase in taxable income that depreciation recapture would trigger at some point when your property is sold.

The Key Benefits of a 1031 Exchange

In a 1031 exchange, you exchange one property for another property of similar value, or what the IRS rules refer to as “like-kind”. And in the process, you avoid paying capital gains tax, at least for a while, and perhaps indefinitely.

The IRS defines “like-kind” property rather broadly, with means both the original property and the new property purchased must be of the same nature, but not necessarily the same quality or type of property. This means you can exchange almost any type of property, and receive the tax benefits, as long as it is investment or business real estate, not personal property.

For instance, you can exchange an apartment building for a duplex. Or, you are allowed to exchange a single-family rental property for a commercial office building or even an industrial warehouse. It’s all allowed under the 1031 exchange.

In fact, you can acquire as many new properties as you like, let’s say ten rental units in exchange for one office space, as long as the value of the properties you intend to purchase are at least 95% or more of the property you’re exchanging.

You’re also free to upsize. Let’s say you’ve outgrown your office or industrial space. You can exchange it for another, bigger property as long as the value doesn’t exceed 200% of the value of the property you’re exchanging.

This is like playing real-life Monopoly, with high stakes money-saving tax advantages to boot!

Also, some of the routine costs you incur in an exchange transaction can be paid for with proceeds from the exchange itself. These expenses and fees include: Broker’s commissions, filing fees and attorney’s fees among other costs.

The way the IRS looks at it, you are simply exchanging one form of your real estate investment for another form, without cashing out and recognizing a capital gain. This allows your real estate investments to grow tax-deferred, like an IRA or 401k investment. Better yet, there’s no limit on how many times or how frequently you can use a 1031 exchange. You can roll over the gain from one piece of investment real estate to another to another and so on down the line.

The 4 Types of 1031 Exchanges

There are four main types of like-kind exchanges investors can choose from. Let’s take a closer look at each and you’ll learn the advantages of each, and which might work best for your own needs.

Simultaneous Exchange

A simultaneous exchange occurs when the newly purchased, or “replacement” property and the just sold, or “relinquished” property both close on the very same day. In other words, the sale and purchase transactions must happen simultaneously.

Keep in mind that any delay, even a short delay caused by transferring money to an escrow agent, can result in the disqualification of the exchange and the full capital gains taxes on the property you sold would be due immediately.

Delayed Exchange

Due to the restrictive timing of a simultaneous 1031 exchange, the delayed exchange is by far the more popular, and most common type of exchange used today. A delayed exchange takes place whenever you sell the original property before you purchase your new, replacement property. You have a maximum of 45 days to identify the replacement property you aim to purchase, and 180 days to complete the entire transaction.

Reverse Exchange

Sometimes as a real estate investor you may want to do things the opposite way around. When you acquire a new replacement property before selling the old property you intend to exchange, this is called a reverse exchange. This type of exchange requires all cash, and many banks won’t offer loans for reverse exchanges.

In a reverse exchange transaction, the property must be transferred to a qualified intermediary as titleholder under a qualified exchange agreement. You must still identify which properties you are going to sell within 45 days, and the transaction must close within the same 180-day window.

Construction or Build-to-Suit Exchange

This type of 1031 exchange allows you to make renovations to the replacement property, or even build a new, replacement property for yourself from the ground up. And you get to use the tax-deferred proceeds from your property sale, to pay for the cost of renovations and/or construction.

Just keep in mind that the money from your exchange proceeds must be used for completed improvements, construction or as down payment by the 180th day. You must receive substantially the same property as you exchanged, and your new property must be of equal or greater value. All improvements and construction must be finished within the standard 180-day period as well.

Bottom line: The tax-deferral and estate planning benefits of a 1031 exchange offers you a great deal of financial flexibility and money savings when it comes to real estate investing. If you would like to find out more and see first-hand how a 1031 exchange can benefit you, simply reach out to one of our experienced pros at TSP Family Office by calling (772) 257-7888. We can walk you through the process step by step to help you simplify your personal and business life at tax time.