Commercial Real Estate News / Investing / Using a 1031 Exchange to Take Advantage of Rental Properties for Sale

Using a 1031 Exchange to Take Advantage of Rental Properties for Sale

Published: 10-27-21 Category: Investing

Specializes in providing actionable insights into the commercial real estate space for investors, brokers, lessors, and lessees. He covers quarterly market data reports, investment strategies, how-to guides, and top-down perspectives on market movements.

A large, luxury commercial real estate building

Real estate investors come from all walks of life, and one thing that all investors have in common is that they have to think about tax implications. That’s right; Uncle Sam knows that real estate is a powerful tool for wealth and investment, and the U.S. Government would like to get their fair share of the profits.

Yet all is not lost: the IRS tax code is complicated, but it does have multiple regulations involving real estate. So we wanted to make sure that when you think about a rental property for sale, you understand the tax implications and the opportunities for growth.

An often overlooked way to handle real estate properties for sale without adding additional tax events is to perform a 1031 exchange. Now, there are entire books written around the nuances of Section 1031, the piece of the tax code that gives its name to this real estate transaction.

We will sum up the most important points. Still, it is always a good idea to follow up any tax information with your accountant and other professionals before putting any new real estate strategies into play.

What is a 1031 exchange?

Simply put, a 1031 exchange allows you to swap one property for another in order to avoid paying capital gains tax right away. Remember that this means that the taxes don’t go away; they’re simply deferred. But some investors like to push back capital gains taxes in order to be able to have money free for more investing opportunities.

The heart of the 1031 exchange rules lies in the idea of like-kind properties, as the IRS requires that the properties truly meet the definition of being similar in nature. The rules for like-kind properties can be quite vague, so it’s important to make sure that you’re looking carefully at the finer details within each transaction.

Advantages of 1031 Exchanges

Let’s start with the multiple benefits that make the complicated journey of 1031 exchanges well worth exploring. Here’s what you need to know:

Tax deferral is one of the leading advantages of 1031 exchanges, as capital gains taxes are deferred completely.
You can get a more profitable property by using a 1031 exchange. Rental properties for sale aren’t created equal, and some are more profitable than others.
If you have a property that isn’t producing income, you can use the 1031 exchange process to get an income-producing property instead.

These advantages lead people to 1031 exchanges, and they are a powerful tool for real estate investors at all levels. As long as you read over the qualifications in detail, you should have no problem using 1031 exchanges to your advantage.

Disadvantages to 1031 Exchanges

Of course, we can’t just give you all of the benefits of 1031 exchanges without being honest about their pitfalls. Here’s what you need to know about the disadvantages of 1031 exchanges:

The regulations are tough and have to be followed to the letter. Getting someone to help you with this process isn’t just a gentle suggestion; it’s practically a requirement to remain within compliance.
The time constraints are very rigid, with no extensions. You have to find a property to replace your original property within 45 days, and that’s pure calendar days. It might sound like a long time, but you’d be surprised at how fast time flies.
Taxes don’t disappear. A common misconception with 1031’s is that it’s a great way to have a sale without capital gains taxes, but that’s not the case. Make sure that you are fully aware of your tax consequences.

Mentioning the drawbacks to 1031 exchanges isn’t designed to make you skip them entirely. If anything, all of these disadvantages can be overcome with the right set of properties. It’s just important to make sure that you’re aware of the risks around this real estate transaction.

Can commercial real estate investors perform 1031 exchanges?

Yes, this is a tool for real estate investors and is also open to non-investor types as well. Since that’s outside of the scope of this guide, we’ll just focus on investors. Rental properties provide great cash flow, and using 1031 exchanges to your advantage is a great way to improve cash flow at both sides of the transaction.

You benefit from deferring capital gains tax, and you improve cash flow because that’s less money that you have to turn over in a specified period. If you’re trying to improve a cash flow snapshot of your real estate investing business, 1031 exchanges can undoubtedly fulfill that goal.

Important Tips for a Successful 1031 Exchange

There are more than a few tips for a successful 1031 exchange, but we wanted to round up the best guidance possible to make any potential deal as successful as possible. Here’s what you need to know:

Understand that after you sell your property, you have to designate a new property that you’re considering purchasing to the intermediary that’s going to hold your funds in escrow.
Remember that you have to close on the property within 180 days of the sale of the original property. If there are going to be issues with closing, it’s best to identify and resolve them as soon as possible.
While you can use 1031 exchanges practically indefinitely, it gets more and more difficult to find properties that fit the exchange’s qualifications. Don’t take risks that will lead to penalties.

Keeping the above tips in mind will go a long way in making sure that you have a successful 1031 exchange and can use the profits to take advantage of rental properties for sale.

While you don’t have to use the 1031 exchange to pick up rental properties for sale, it certainly doesn’t hurt. It’s a good way to have capital gains taxes deferred, but only if you follow the points of the exchange to the letter. Again, getting a real estate attorney that’s deeply experienced with 1031 exchanges is a good idea. Staying in compliance with the IRS should be everyone’s top priority, after all.

List & Browse Rental Properties for Sale Near You for Free on MyEListing.com!

You can list and browse rental properties for sale near you for free right here on MyEListing.com. Sign up for an account to receive customized property type notifications via email and download our mobile app.