Real estate investment properties can offer many potential benefits, including important tax breaks, stable cash flows, passive income, portfolio diversification, and asset appreciation.
In today’s frothy real estate market, where demand for investment properties often outstrips availability, investors may be considering divestiture of certain real property assets to capitalize on high asset appreciation. You’ll be on the hook for any realized gains above your investment basis in the asset, though, unless you complete a 1031 exchange.
Real estate investors have used 1031 exchanges for decades as a means to defer capital gains taxes. Investors who sell investment assets can defer taxes on any realized gains by rolling over all of the sale proceeds into another property. Real estate rollover is unique to the 1031 exchange process and allows investors to defer capital gains, trade up in asset class and worth, and diversify their portfolios.
Example of Real Estate Rollover
Rollover has long been associated with individual retirement accounts. If you leave a job and you had an employer-sponsored 401(k), you can rollover or transfer the funds from that account into a new IRA without incurring any penalties or tax obligations.
Real estate rollover is the heart of a 1031 exchange. Selling an investment property outright, especially one with significant asset appreciation, can generate a taxable event that erodes overall profit. Long-term capital gains taxes for assets held more than one year are either 0, 15, or 20 percent depending on your income for that tax year. If you are a single filer who will report more than $445,850 in taxable income for 2022, you’ll pay the top rate of 20 percent in capital gains taxes.
Here’s the difference between selling an investment property outright versus rolling over the sale proceeds and completing a 1031 exchange, assuming a 20-percent capital gains tax:
Original basis: $1 million |
Straight sale |
Asset sale price: $2 million |
Capital gains tax at 20%: $200,000 ($1 million @ 20%) |
Funds available for reinvestment: $1.8 million |
Original basis: $1 million |
Rolling proceeds over into a 1031 exchange |
Asset sale price: $2 million |
Capital gains taxes due after a 1031 exchange: $0 |
Funds available for reinvestment: $2 million |
Real estate rollover increases the purchasing power of your investment dollars and preserves your investment capital.
Real Estate Rollover Property Types
Real estate rollover in a 1031 exchange is limited to “like-kind” properties. The Internal Revenue Service defines like-kind real estate assets as those that are of similar nature or character, even if they are different quality or grade.
Essentially, that means when you are looking for replacement properties for a real estate rollover in a 1031 exchange, you should be looking for the same kind of property – exchanging a single-family investment property for another one, or a duplex for a tri-plex or larger multi-family property. You can do a real estate rollover from a 1990s residential investment property into a newly built house (higher asset quality) or a Class C apartment complex into a newer Class A multiplex (higher asset grade).
One important aspect of 1031 exchanges is that the replacement property must be held for investment purposes. You can’t rollover the sale proceeds from an older single-family investment property into a new house that you intend to live in – the replacement asset has to be a rental, at least for a period of time to make sure you can satisfy the strict exchange requirements.
The Bottom Line
Real estate investments offer many potential benefits for investors. Real estate rollover through a 1031 exchange can do the same by preserving more of your investment capital and allowing you to purchase assets of greater value or higher quality. Consulting with professionals experienced in 1031 exchanges can help investors learn more about the potential benefits of real estate rollover.