Welcome back! This is the second part in a series we’re doing about the benefits of 1031 exchanges. If you missed part one, check it out by clicking this link.
To recap, let’s briefly summarize the 1031 exchange, which allows you to exchange one kind of like-kind property for another. In this process, you sell a property, and use the proceeds to purchase a like-kind property to avoid paying the dreaded capital gains tax.
Maximizing your tax savings is crucial to compounding your wealth. Keeping more money each year with strategies like a 1031 exchange can unlock compounding at higher rates than traditional methods, allowing you to reach your financial goals faster and more efficiently.
Today, we’ll go into greater depth on strategies for lesser known forms of the 1031 exchange. We’ll even cover a strategy I call the “lazy person’s 1031 exchange,” which mirrors a traditional exchange by letting you defer capital gains.
And before we begin, always remember to consult the team of professionals in your corner—your CPA, your tax strategist, and others on your financial team—before taking action. These experts will help guide you and keep your tax strategies aligned with your financial goals.
Partial Exchanges
To get things started, let’s look at a partial 1031 exchange. This is when you exchange a portion of the proceeds from a sale of one property for ownership (or a percentage of ownership) in another property.
This offers incredible flexibility when it comes to tax strategies because you can defer capital gains on some of the proceeds from the relinquished property while still being able to use the rest of the money for other purposes.
And if you are looking to diversify your real estate investments, a partial exchange could help you reinvest the proceeds from a sale into a new property and alternative forms of real estate investing, like REITs or syndications. Essentially, a partial exchange allows you to save on taxes and generate capital for other investments.
The amount you keep is called the “boot,” and you can collect it as cash or put it toward the mortgage of the new property, called the “mortgage boot.” Both a cash and mortgage boot are taxable in the year of sale. And by paying taxes on some but not all of your sale proceeds, you can spread out your tax liability over time depending on your financial strategy.
Multi-Party Exchanges
With multi-party exchanges, owners will swap one like-kind property for another, typically at the same time. There are three kinds of multi-party exchanges. Let’s look at each.
Two-Party or “Swap” Exchange
In a two-party exchange, one investor conveys their relinquished property to the other party in exchange for the replacement property. In other words, it’s when one party swaps deeds with another.
This is an extremely rare form of the 1031 exchange because it can be difficult for two parties to find properties that are the exact value. A two-party exchange can occur with properties that don’t match value, but whoever is left with the boot may be subject to capital gains tax.
A two-party exchange does not require a qualified intermediary (QI) to complete, so it is an option that could save on fees. But a general roadblock to this exchange is timing the swap to occur on the same day, something which a QI can help with.
This can be a savvy way to save on taxes while diversifying your portfolio. For example, one way to diversify is to own doors in different markets. You may discover that you are carrying a lot of risk by having too many investment properties in one area. To solve that issue, you could identify another investor in another market who’s in a similar situation and agree to exchange properties to relocate some of your assets into a new market. This way, you are able to buy into another market without having to pay capital gains tax to do so.
Three-Party Exchange
Sometimes we should explore a strategy because it’s good to learn about what not to do. Learning about the three-party exchange is one of those times. Most tax advisers will not recommend this method. So let’s figure out why.
In this type of exchange, here are the three parties involved: 1) an investor looking to acquire a property without a like-kind property, 2) the seller of the investor’s target property, and 3) an owner of a like-kind property of equal of greater value that the investor hopes to acquire as part of the exchange.
Because there are three parties, one must act as the “accommodating party” that facilitates the transaction. This could occur in two different formats: the Baird or Alderson exchanges. In the Baird version, the title passes through the seller, and in the Alderson version, the title passes through the intended buyer. This “accommodating party” format is highly risky because it forgoes the security of using a title company or QI. For example, very little documentation will be produced to record the deed exchange. Additionally, now associated with the title, the accommodating party could be exposed to any issues connected to the property (think easements, liens, etc.).
Simultaneous Exchange with a QI
This is when a QI is used to structure an exchange of properties that will occur on the same day. Why does this require a QI? The 1991 Treasury Regulations state that the only “safe harbor” for a simultaneous exchange is using the services of a QI.
The good news is that much of the work will be taken off your plate. The QI will prepare the agreement, provide written instructors, and handle all documents for a nominal fee. Considering the amount you’ll save, you will want to pay a good QI who can make sure it’s done right. This insulates the exchange from constructive receipt issues. There is quite a bit of flexibility with this exchange, if you’re looking for that. Simultaneous exchanges can easily convert into delayed exchanges, eliminating the time pressure of trying to close the entire transaction simultaneously. In terms of tax deferral strategies, this flexibility allows you to target a more efficient exchange while still leaving your options open if it proves too difficult to trigger a simultaneous exchange.
Construction and Improvement Exchanges
These exchanges give the exchanger the opportunity to use proceeds from the sale of the relinquished property in unique ways. The funds could build new construction, as is the case with the construction exchange. Or they could renovate an existing property with an improvement exchange.
All work must be done within 180 days from the sale of the relinquished property in order to qualify for the 1031 exchange deferral on capital gains.
When I say that 1031 exchanges are great for trading up in real estate value, this is a clear example. Think about it. The funds that pay for improvements or construction can be used to increase the value of the replacement property to above the sale value of relinquished property.
This is the “fix and flip” of the 1031 exchange world. And it works best for small construction or renovation projects because they stand a better chance of being completed before 180 days are up.
Keep in mind, these exchanges can be more expensive. So make sure you work closely with your financial team on this type of exchange. Usually title feels, escrow fees, closing costs, transfer taxes, and exchange fees tend to be higher with this option. And, in my experience, loans are more expensive.
Reverse Exchanges
The reverse exchange operates in the, well, reverse order of a traditional exchange. First, you would buy the replacement property and then sell the relinquished property. The like-kind rules still apply in these exchanges.
The advantage to this option is clear: You have the ability to find and close on a replacement property without needing to first sell a current property. That gives you the freedom to search for properties with less concern for timing. After you close on the new property, you would have 45 days to target one of your own like-kind properties. Considering you know your portfolio pretty well, that shouldn’t be an issue.
That freedom comes at a price, though, as the investor will need the financial means to make the new purchase before executing the 1031 exchange.
The Lazy Person’s 1031
Technically, this isn’t actually a real 1031 exchange. It’s in investment in syndications. When a syndication sells, you’ll have a taxable amount of money you made from that sale.
However, in that same year, if you plan correctly, you can “exchange” one deal for another, so to speak. Let me explain. Most syndications are clear about when a sale will occur. With careful planning, you could take on a new deal the same year you earn taxable income from a syndication sale. Taking the paper losses from the new deal’s depreciation could offset the taxes you owe on the sale. Some call this strategy a syndication ladder, where they exit one deal and immediately go into another.
Let’s look at an example. Let’s say a syndication deal nets you $100K, which would normally be subject to capital gains. You could then invest in other syndication deals that year and take depreciation or cost segregation—a concept we’ve talked about before—to create $100K of paper losses to offset your tax burden.
No taxes paid; more investments made.
For those of you inclined to the more passive route of real estate investing, this is a great option. You can invest in real estate without being hands-on with property management, property targeting, and other factors of a 1031 exchange. Instead, you’ll be doing due diligence on different syndications as you climb the ladder.
The 1031 Advantage
As we conclude the second part to our 1031 exchange series, I hope you feel better equipped to work with your financial team when considering 1031 exchanges to offset the impact on your taxes. Navigating your real estate investments to alleviate taxes helps you compound your returns and opens the opportunity for enduring wealth.
Over the years, I’ve used 1031 exchanges to do just that. Keep using real estate to put more money in your pocket while you let passive income create generational wealth for you and your family.
If you’d like to keep this discussion going, we’d love to be part of it. Think about joining PREA, attending one of our many events, or being part of one of our many communities to start working with like-minded people on life-changing investment opportunities. Thanks for stopping by today! Stay inspired to meet and exceed your financial goals!Peter Kim, MD is the founder of Passive Income MD, the creator of Passive Real Estate Academy, and offers weekly education through his Monday podcast, the Passive Income MD Podcast. Join our community at the Passive Income Doc Facebook Group.