If you read about the 1031 exchange, you'll immediately think it's the greatest thing on earth for real estate investors. What's not to like about paying zero capital gains tax after the sale of a property? However, this article will discuss the various reasons not to do a 1031 exchange to save on taxes.
The government already taxes real estate investors through an annual property tax and a transfer tax upon sale. Having to pay capital gains tax on the way out can be very painful. This is especially true since real estate prices have surged to all-time highs in many areas of the country.
This article explores the other side of the 1031 exchange. We will talk about reasons not to do a 1031 exchange to save on taxes. As a real estate investor, it's always wise to understand both sides of the equation.
First, let's discuss what is a 1031 exchange.
What Is A 1031 Exchange?
A 1031 Exchange allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long as another “like-kind property” is purchased with the profit gained by the sale of the first property.
To do a 1031 exchange effectively, you must exchange one property for another property of similar value. Further, the purchase price and the new loan amount has to be the same or higher on the replacement property.
Why I Considered Doing A 1031 Exchange
In my case, I had to find a single family or multi-unit property worth at least $2,740,000. I could find a property worth less than $2,740,000 after I sold it. However, then I'd have to pay the capital gains tax on the difference in sale price and purchase price of the new property known as “boot.”
The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind.
After the properties are identified, the investor has 180 days to make the purchase and initiate the exchange OR by the due date of the income tax return with extension, whichever is earlier.
Finally, you've got to pay a Qualified Intermediary anywhere from $1,000 – $3,000 to hold your proceeds (you never get to see or touch the proceeds from your home sale) to conduct the exchange.
If you are unable to identify and buy a new property, you lose that money and all that time.
Main Reasons Not To Do A 1031 Exchange
Now that we understand what is a 1031 exchange, let's discuss reasons not to do a 1031 exchange.
1) You don't mind paying taxes
2) You haven't found the right property
3) You want to reduce exposure to real estate
4) You want to simplify your life
5) You've lived in your rental for at least two of the past five years. Therefore, you can take advantage of the $250K/$500K tax-free profits
Why I Didn't Do A 1031 Exchange
In 2017, I sold a rental property for $2,740,000 in San Francisco. As a new father, I just didn't want to deal with rowdy tenants and maintenance issues anymore. Further, rents were dropping a little at the time.
I decided to reinvest $550,000 of my sale proceeds into real estate crowdfunding to simplify life. So far, it's been a great move as the investments have returned over 10% a year. Further, all the income earned has been passive.
Trading one expensive property for another expensive property just to save on taxes wouldn't achieve my goals of simplification. After selling, I felt a little like I escaped death. I had gone through the financial crisis with a huge mortgage and came out unscathed.
With an equally expensive San Francisco property out of consideration, I looked at Honolulu property for a 1031 exchange. We're considering moving back to Honolulu once our son is eligible for kindergarten in 2022.
Given Honolulu is cheaper than San Francisco, we'd end up buying an even larger property through a 1031 exchange. That wasn't simplifying life. Or, we could buy our retirement dream home near the beach. But it would have to be rented out for at least one year, if not two years for it to be considered rental property by the IRS.
1031 Exchange Through Real Estate Crowdfunding
Finally, I asked Fundrise, my favorite real estate crowdfunding platform, whether they had any properties on their platform eligible for a 1031 Exchange. At the time my house was to close, they said they didn't, but that something was in the works.
About a month after my transaction closed, Fundrise sent me an e-mail saying they had launched their first 1031-eligible property. It was a 272 unit multi-family project looking to raise $4,500,000 in Houston, Texas. It had an 8-year holding period, and a 13% target IRR.
I'm fine with an 8-year holding period. However, with $2,740,000 million to put to work, I would take up more than 50% of the deal size. I don't recommend anybody account for greater than 10% of any deal due to concentration risk. Further, think about how stressed I would be before, during, and after Hurricane Harvey hit.
As I thought about this close call, I realized the primary purpose of de-risking and simplifying life is to minimize stress. Up until my son was born, almost all the stress I had was dealing with real estate maintenance issues and tenants.
De-risking Is About Stress Management
I already got rid of work stress in 2012 by negotiating a severance. I got rid of money stress by hitting a net worth target and reaching a passive income goal. Online work is not that stressful because writing comes easy to me. There are only a few truly thoughtless people who like to say unthoughtful things.
From a financial perspective, although the gross gain from selling my rental home was ~$1.22M and ~$1.8M hit my bank account after years of paying down the mortgage, the taxable gain is much less due to the $250K/$500K tax-free gain exclusion. Then there are selling expenses and home remodeling expenses one can deduct to lower tax liability.
For example, theoretically, I could pay no capital gains tax if I spent $600,000 remodeling the house and $150,000 selling my house. When you add the $500K tax-free exclusion, the total is $1,250,000, or more than the gross profit I received.
In this example, the negative of not paying taxes means the gains weren't much greater than the tax-free gain exclusion amounts. But at the end of the day, I'm left with $1.8M in the bank. Not bad compared to the $305,000 downpayment I first down in 2005.
I've set aside $150,000 for capital gains tax (federal + state) next year. It's been nice to not own this rental property anymore. Maintenance and tenant issues seem to always come up!
Focus On What's Most Important
For all of you considering doing a 1031 exchange, consider these reasons on why not to do a 1031 exchange.
1) If you cannot find the right property to reinvest the proceeds, don't do a 1031 exchange.
It would be foolish to try and save on taxes, but then lose principle value because you bought the wrong property at the wrong time in the cycle. You might feel a lot of pressure to identify three properties to purchase in 45 days. Then you might pay a bad price since you've got to close within 180 days.
Unless you absolutely love the next investment property, it's not worth doing a 1031 exchange.
2) Don't let your tax bill dictate your decisions.
A large tax bill is usually great because it means you made an even greater profit. I remember plenty of folks during the 2000 dotcom bust who refused to sell their stock after they exercised their options because they wanted to let things ride.
But when their stock eventually went to zero, not only were they left with nothing, they also had to pay taxes on the difference between the exercise and the strike price at the time. Only do a 1031 exchange if you've found the right property opportunity.
3) Focus on lifestyle first, money second.
Your real estate investments should serve you, not the other way around. Even if we found our dream home in Honolulu, we wouldn't move because we don't want to leave our lifestyle in San Francisco just yet.
We just finished completely remodeling our house. We have our doctors we've trusted for years and a pediatrician and ophthalmologist we like for our son. We've got a set of friends we enjoy hanging with. And we've also scoped out and applied to several pre-schools too.
4) Will you really be able to hold on forever?
A 1031 Exchange allows you to delay paying your taxes. It doesn't eliminate your capital gains tax. Only if you never sell your 1031 exchanged property or keep on doing a 1031 exchange, will you never incur a tax liability.
You can pass on your property to your children who get to step-up the value to current market value. This way they never have to pay taxes on your property either.
It's only after your assets exceed the estate tax limit ($12.92 million per individual, double for a couple in 2023) do your heirs need to pay ~40% tax on anything over. The median holding period for property in America is between 7 – 8 years.
5) Do you really need the rental income?
A 1031 exchange is exclusively for rental properties, not primary residences. Therefore, the primary reason to own rental property is for income. Income streams can change over time, as they have for us. I thought we would need the rental income forever because we never wanted to go back to work.
Little did we know that during the three years we tried renting out the house, our online income grew to the point where we definitely didn't need rental property anymore. Even if our online income was slashed by 80%, we still wouldn't need any portion of our rental income in our passive income portfolio.
That said, post-pandemic, I am bullish on rental properties. As a result, I'm actively seeking to invest in multifamily properties and build-to-rent properties on CrowdStreet.
CrowdStreet focuses on such investments in 18-hour cities, where valuations are lower and rental yields are higher. You can sign up here and see what they have to offer for free.
A Simpler Life Feels Great
In a perfect world, I would have 1031 exchanged all the proceeds into a diversified private real estate fund that returned at least 10% a year forever, guaranteed.
Alas, I was unable to find such an opportunity. I've already redeployed over half the proceeds in 100% passive investments. The remaining proceeds will more than likely stay liquid in order to finally buy that dream home in Hawaii one day.
If you would like to do a 1031 exchange, I recommend identify a handful of rental properties you want to buy before proceeding. This way, you do the 1031 exchange much quicker without as much pressure.
The housing market will likely stay strong for a very long time. Therefore, owning real estate as part of your investment portfolio is a wise move. Just make sure you are doing a 1031 exchange for the right reasons.
Explore Real Estate Crowdfunding
If you're looking to buy property as an investment or reinvest your house sale proceeds, take a look at Fundrise, one of the largest real estate crowdfunding platforms today with over $3.3 billion in assets and 400,000 investors.
Fundrise enables everyone to invest in residential and industrial commercial real estate deals across the country that were once only available to institutions or super high net worth individuals. Its investment minimum is just $10.
If you are an accredited investor, also check out CrowdStreet. The platform offers individual real estate investment opportunities mainly in 18-hour cities. 18-hour cities are cities with faster growth and lower valuations.
I've met a dozen people from CrowdStreet before and am very impressed with their offerings. Just make sure to thoroughly review the sponsors before investing in individual deals. With CrowdStreet, it's important to build a diversified select portfolio of your own.
I've personally invested in $810,000 in 18 different commercial real estate crowdfunded properties across the heartland. My goal is to earn passive income and diversify my expensive real estate holdings.
Reasons Not To Do A 1031 Exchange is a Financial Samurai original post. I've been writing about achieving financial freedom and investing in real estate since 2009. Join 60,000+ others and sign up for my free private newsletter today.