As a multifamily investor, you likely know that taxes are due any time you sell a property. However, Section 1031 of the IRS tax code provides a unique opportunity: When selling, you can defer those taxes if you reinvest in another property within 180 days, giving you the liquidity you need to build or augment your real estate portfolio.
Let’s walk through the basics of 1031 exchanges to understand how the process works, what the benefits are and why timing is a critical planning point.
Tax Deferred Exchanges date back to the 1920s and were introduced to stimulate economic activity, investment and wealth creation. Today, the tax exception is granted under Internal Revenue Code Section 1031.
This part of federal tax law regulates “like-kind exchanges” and allows for taxes to be postponed when proceeds from the sale of an investment property are reinvested into a replacement property. This is referred to as a “swap,” and all types of real estate qualify under Section 1031.
“At its core, Section 1031 pushes the economy forward by enabling investors to buy more real estate without being subject to immediate tax costs,” says Jennifer Keen, Executive Vice President at IPX1031, a business that helps facilitate 1031s as a qualified intermediary.
Essentially, Section 1031 allows investors to sell a property without requiring them to recognize a gain or loss, which would trigger tax payments. Even if a sale nets a profit, the investor can roll the tax-deferred gain over to the next property, and so on, as there’s no limit on the number of times an owner can transact through Section 1031.
One reason Section 1031 is so advantageous is because any multifamily owner is eligible. All owners of investment properties can conduct 1031 exchanges as individuals or as an incorporated business, partnership, limited liability corporation or any other recognized, tax-paying entity.
The definition for “like-kind” is not as stringent as you might think. That’s to say, “like-kind” does not mean only properties of the same size, asset class or unit count can be exchanged. You could sell a three-flat with the intention of acquiring a larger apartment complex and it would still be considered a like-kind exchange.
Owners are afforded even more flexibility because the swap doesn’t have to be one for one. You could relinquish one property and buy two — so long as the acquired properties cost as much or more than the sale price of the relinquished property. Alternatively, you can consolidate by selling multiple small properties and buying one large property, so long as the value of the new one is equal to or exceeds the that of the old one. If you purchase down in value, you can still complete a 1031 exchange; only the difference would be subject to tax.
Section 1031 can only be used in swaps where the deal is mutually dependent on both the relinquishment of one property and the acquisition of another. For example, you can’t cash out on one property and then buy another at a later time and defer taxes under the code. An owner must proactively identify the replacement property (or properties) they want to buy for Section 1031 to apply.
“At its core, Section 1031 pushes the economy forward by enabling investors to buy more real estate without being subject to immediate tax costs.”
While tax postponement is a major advantage to 1031 exchanges, it’s far from the only one. According to Keen, some of the other major benefits these swaps offer include:
It’s crucial to have a well-thought-out plan for using Section 1031.
“Timing is often the most challenging part of the exchange process,” Keen says. “There’s no room for procrastination.”
There are two timeframe rules you should understand before moving forward with any Section 1031 plans. According to Keen:
There is next to no margin for a time management error. The IRS holds that “these limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.”
Section 1031 may fly under the radar for many multifamily owners, as federal tax law can be dense. Some other important things to keep in mind, per Keen, include:
While conducting a Section 1031 exchange requires walking a fine line, the process can offer a valuable opportunity to build your portfolio.