Tips for using a 1031 exchange
Before jumping into real estate investment, find out how a 1031 exchange can benefit you
It’s a seller’s market in Denver. A high demand for houses and a lower inventory of available homes has sent housing prices skyrocketing nationwide during the past year. But there may be some relief for buyers in the Denver area.
While the local real estate market remains hot, it shows signs of cooling this summer. With many buyers giving up on purchasing a home for now, more houses are staying on the market longer than they have in the past year.
This market change could spell good news if you’re interested in building your wealth through real estate investments. By using a 1031 exchange, you can make the most of your real estate profits during the still-hot market by investing in one of the hottest real estate markets in Colorado.
Before jumping into real estate investment, find out how a 1031 exchange can benefit you.
What is a 1031 exchange?
IRS Section 1031 allows investors to defer capital gains taxes from the sale of one investment property by rolling over the profits into the purchase of a like-kind property within 180 days of the sale.
There is some room for interpretation on what constitutes a like-kind exchange. For example, if you sold an individual-family home, you could roll over the profits by purchasing a townhouse, condo, or even a parcel of land for development.
How does a 1031 exchange benefit investors?
Savvy investors have been able to build wealth over time by deferring tax payments through 1031 exchanges.
For example, if an investor bought a single-family home for $612,395 in May 2020, which was the average sale price in Denver County according to the Colorado Association of Realtors, in May 2021, they sold that home for the average price of $820,412. Through a 1031 exchange, the investor can defer the taxes on the $208,017 profit by investing that amount in a new property.
The code also covers investment-related expenses, such as paying commission fees for real estate agents or making improvements on the property.
At present, there is no limit to how many times or how often you can use a 1031 exchange. You can keep deferring indefinitely until you eventually sell the property for cash. At that point, you would only pay one tax instead of taxes on a lifetime of investments.
How can you use a 1031 exchange?
Real estate investments are one of the best and surest ways to grow your wealth over time. If you’re interested in using 1031 exchanges to meet your real estate investment goals, it is important to understand how the tax code can and can’t work for you.
First, it’s important to know if now is the right time to make a 1031 exchange on your property. An ideal candidate is one that is near maximum appreciation. With the Denver market hot, but starting to cool, some properties are reaching this point.
Not all properties are created equal. If your property has depreciated in value, or if your mortgage rate will give you a low return on investment, you may want to wait and hold onto that property.
If you would like to test the waters on using a 1031 exchange to build your investments with lower stakes, you might consider a Delaware Statutory Trust. A DST allows an unlimited number of investors to jointly own real estate. A company, known as the sponsor, collects the investment money and handles the day-to-day of property sales and rents. DST investment periods typically run for five to 10 years.
As an investor in a DST, you will regularly receive payments for your investment without having to manage the details. To learn more about DSTs that might be right for you, find a qualified broker-dealer who can manage a 1031 exchange DST on your behalf.
What are special considerations for a 1031 exchange?
A 1031 exchange does come with some exceptions and stipulations. You are required to pay taxes on any amount of profit that is not invested into the new property. For example, if you made a $200,000 profit on your sale but purchased a like-kind property for $150,000, you would need to pay taxes on the $50,000 difference.
You must also follow set procedures if you decide to turn a home purchased through 1031 exchange into your primary residence or vacation home. The safe harbor rule states that in each of the two 12-month periods following the exchange, you must rent the property to another person at a fair market rate for 14 days or more, and your personal use of the property cannot exceed 14 days or 10% of the days the unit was rented during that 12-month period.
As with any tax code, it is important to work with accountants or experts who fully understand how 1031 exchanges work to avoid having your investment become a pain point. There are companies that specialize in stewarding 1031 exchanges, including ones that operate in the Denver area.
Kristen Herhold is the PR editor at Clever, a real estate data firm. In her free time, she enjoys reading, traveling, and cheering on the Denver Broncos and Missouri Tigers. Connect with Kristen on LinkedIn, or reach out to her at email@example.com.