What if we told you there’s a way to sell and acquire a new real estate property while deferring taxes? This approach is not a gray-area legal loophole but a valid one — the 1031 exchange.
While it might be new to you, the 1031 exchange has been the go-to technique of numerous experienced real estate investors to defer capital gains taxes. Learning and adopting this process will help you save more money and elevate your real estate investment strategy.
Know the Essentials of 1031 Exchange
If you have zero clue what a 1031 exchange is, we have your back. In the following sections, we’ll help you get acquainted with the process and how it will benefit your investments.
What Is It?
In a nutshell, a 1031 exchange is the process where you “trade” your real estate investment to another “like-kind” property to defer capital gains taxes. The name “1031” stems from section 1031 of the Internal Revenue Code (IRC), which is the legal statute covering this exchange. We’ll talk more about the specifics of the 1031 exchange.
The explanation provided above is an oversimplification of the 1031 exchange. In truth, this process involves a lot of moving parts, which could confuse non-professionals. The “like-kind” requirement is broad and often vague, which is why it’s always debatable in a transaction. The consensus is that both properties should be for investment or business purposes.
Are Capital Gains Taxes Bad?
With all these efforts to defer capital gains taxes, how bad are they really? Capital gains taxes are not inherently bad — they’re just a way for the government to earn revenue from the sale of your property. Capital gains tax is the tax applied when you sell an asset (house, investment, etc.) at a price higher than when you bought it. For example, you bought a commercial property for $400,000 in 2016. With appreciation, property potential, and renovation, you sold it at $600,000 in 2023. Capital gains tax applies on the $200,000 difference.
As stated, these taxes are not bad — but if given the chance to defer paying this, why wouldn’t you take advantage of it?
How Does a 1031 Exchange Work?
Now, let’s discuss the nitty-gritty. Here’s how a typical 1031 exchange works:
- Select a Qualified Intermediary: A qualified intermediary is a professional who will facilitate the 1031 exchange.
- Selling an Investment Property: Once you hire a qualified intermediary, you need to decide on the property you want to sell.
- Buying a Like-Kind Property: You should look for a “like-kind” investment property and use the money you earned to buy it.
- Be Wary of Time Limits: The entire process should only take 180 days or less; otherwise, the 1031 exchange exemption won’t apply.
You can do as many cycles of 1031 exchanges as you feasibly can. Once you sell your property for cash and stop, the long-term capital gains tax will only apply once, saving you lots of money.
Timeline and Rules
Two timeline rules apply in a 1031 exchange: the 45-day rule and the 180-day rule:
- The 45-day Rule: Within 45 days after selling your property, you should declare up to three properties you intend to buy in writing. In some cases, you can name more than three properties.
- The 180-day Rule: As mentioned in the previous section, you should complete the sales process within 180 days of selling your old property.
Tax Implications
After selling your old property and buying a new one, you might have extra cash left. Unfortunately, this money is not yours fully to enjoy. Capital gains tax would apply in this situation.
The remaining cash after a 1031 exchange is colloquially called the boot. The IRS will consider the boot as income from the transaction, which would trigger the capital gains tax. You have to pay this tax, or you will incur legal penalties.
Is It Beneficial?
Despite the boot capital gains tax, the 1031 exchange remains a useful strategy to consider for your real estate investment vehicle. Here are some reasons why you should consider this tactic for your holistic investment strategy:
- Tax Deferral: If the 1031 exchange is successful and you have no boot, the capital gains tax from the transaction will be deferred until you sell your new property in cash. This deferral will give you more money to reinvest and potentially build wealth.
- Minimal Tax Implication: While you have to pay for the boot’s tax, it’s lower than paying the capital gains tax from a house sale.
- Potential Wealth Building: You can use the vagueness of the “like-kind” property requirement to your advantage. It’s possible to sell your property and buy another “like-kind” with greater resale value, so long as it fits the criteria.
- Flexibility: The 1031 exchange process isn’t limited to your location. Even if you’re in Colorado, you can do a 1031 exchange in California or Utah; just be wary of differing state rules in the 1031 exchange.
Understanding 1031 Exchange in Colorado
The general rules of the 1031 exchange in federal law apply in Colorado with minor changes. The 1031 exchange rules in Colorado require the involvement of a qualified intermediary, which is a standard practice in most states.
Another nuance in the 1031 like-kind exchange in Colorado is the explicit use of the term in the contract. Some sellers or buyers in different states can leave out their intention to use the property for a 1031 exchange, which is not illegal. However, it’s standard in Colorado contracts to divulge this information explicitly.
Other than those mentioned, you only have to study the general process and practices of a 1031 exchange and hire the help of an experienced and competent local qualified intermediary, and you’re good to go.
What Does 1031 Exchange Look Like in Different States?
Most states in the country adhere to the general principle of the 1031 exchange, but some state governments may sprinkle in specific provisions to better regulate the process in their jurisdiction. Take note of these differences:
- Clawback Provisions: As shared earlier, you can do a 1031 exchange across state lines. However, if you sold a property from a state with clawback provisions and bought a new property in a different state, the original state could “clawback” taxes on the capital gained from the sale. This tax applies on top of other tax implications, which could result in double taxation.
- Income Tax Differences: Similar to the above situation, you could incur additional taxes when selling property in a state with a different income tax treatment. Colorado is a state with a flat income tax; if you sell a property from a state with a graduated income tax, the state could withhold some of the earnings from state income taxes.
In the past, Pennsylvania was the only state that didn’t recognize the tax deferral of the 1031 exchange. However, a recent regulatory update allowed the state to recognize the 1031 exchange with state-specific tax implications.
To Summarize
The 1031 exchange rules in Colorado have some differences from the standard federal regulations. Understanding the basic structure of 1031 in Colorado and hiring a qualified intermediary should suffice to jumpstart a 1031 exchange. However, complications arise when attempting a 1031 exchange across state lines.
1031 exchanges are complicated processes, and there’s no denying it, but the potential attracts many real estate investors to brave the risks. If you want to sell an investment or commercial property, you might want to consider this approach first to potentially make a significant return in the future.
We’re Here To Help
Wealth building is a long-term and intricate process. A 1031 exchange is only one of the many potential wealth-building vehicles you could use to grow your investment and build sustainable wealth. If you need help exploring your investment options, our experienced and brilliant financial advisors can help you determine the best wealth-building strategy for your current situation.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.steadily.com/blog/colorado-1031-exchange-rules-for-real-estate-investors
https://www.evolvedenver.com/1031-exchanges-denver-colorado
https://www.tfsproperties.com/colorado-1031-exchange-guide/
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
https://www.rocketmortgage.com/learn/1031-exchange
https://seracapital.com/1031-exchanges/things-to-know-about-1031-exchanges-across-state-lines/
https://fnrpusa.com/blog/1031-exchange-different-state/
https://www.investopedia.com/terms/c/clawback.asp
https://1031x.com/offices/denver/
https://taxfoundation.org/data/all/state/state-income-tax-rates-2024/
https://www.marcumllp.com/insights/pennsylvania-to-recognize-section-1031-exchange-tax-deferral
