Is This a Good Time To Do a 1031 Exchange?
Home values are soaring in areas like Dallas-Fort Worth, Houston, Waco and other parts of Texas. With nearly 150,000 people moving into the Dallas-Fort Worth area every year, the real estate market is hotter than ever.
In fact, real estate markets across the country are showing increased home values. At least 27 cities are in a housing bubble, where it could be perfect time to sell due to all-time high home values.
If you have investment properties that are poised to give you equity, this is a great time to consider doing a 1031 exchange.
What is a 1031 Exchange?
The 1031 exchange is the “exchange of real property held for productive use or investment.” It’s a tax exception granted in the IRS tax code as a way for real estate investors to defer capital gains tax. If you sell an investment property and then turn around and use those profits to buy a like-kind investment property, you defer the capital gains tax on the profits from the sale.
You should always confer with a certified tax specialist when using the 1031 exchange. There are lots of rules surrounding this tax exception, including:
- You can’t purchase property for private use; it must be an investment property
- You must hold the property for a minimum of one year
- You must buy another investment property within 180 days
- All the properties must be bought and sold in the same name
- You must identify another investment purchase within 45 days
- You must buy and sell like-kind properties
Here’s a great example of how a 1031 exchange would work in real life:
Let’s say you purchase a rental home for $100K. Over the course of several years, it appreciates to $500K. That’s a $400K profit that you’d have to pay capital gains tax on. If you instead use that profit to buy a like-kind property within the time limit, you pay zero capital gains tax. That’s why the 1031 exchange is so exciting.
Capital Gains Tax in a Nutshell
Everyone wants to avoid paying capital gains tax whenever legally possible, and for good reason. Capital gains are the profits that you make from the sale of assets. Capital gains tax can drain whatever profits you made from your real estate investment transaction. How much capital gains tax you pay depends on several factors including how long you hold the property and what tax bracket you’re in. There are two kinds of capital gains tax to be aware of; short-term and long-term.
Short-Term Capital Gains Tax
This is the tax due on assets you hold for a year or less. The rate is equivalent to your tax bracket. So if you’re in the 20% tax bracket ordinarily and you were going to flip a house in the span of one year, you’d pay short-term capital gains tax at 20% on that transaction.
Long-Term Capital Gains Tax
Long-term capital gains tax is what you would pay on assets you hold for a year or longer. These percentage rates are calculated in increments of 0, 15 and 20, against your taxable income and filing status. For instance, for single filers (as of 2018), if your taxable income is $38,600 or less, you’d pay 0% in long-term capital gains tax. If you make between $38,601 and $425,800, your long-term capital gains tax rate is 15%. If you make $425,801 or more, you pay the maximum long-term capital gains tax of 20%.
Now, here’s the kicker. You have to include the profits from the sale of your asset as part of your income before calculating your capital gains tax. So it’s entirely possible that your transaction profit kicks you into a higher income category and you’ll pay at the higher capital gains tax rate.
Here’s an example of how capital gains tax digs into your profits:
- You buy a house for $200K.
- 21 months later you sell at $230K.
- Your profit is $30K.
- You earned yourself a 15% return on the investment!
- Now it’s time to pay Uncle Sam.
- Your income is $220K, plus the $30K brings you to $250K.
- You’ll pay long-term capital gains because you held for more than a year. Your long-term capital gains rate (filing single) will be 15%.
- On that $30K profit, you’ll pay taxes of $4500
- Your return on the investment, less capital gains tax, is now only 12%.
How the 1031 Exchange Benefits You Now
These are some of the benefits you can expect from doing a 1031 exchange now.
- With a $400K profit from selling an investment property that you bought for $100K and sold for $500K, you could defer capital gains tax of up to 20% indefinitely. That’s a tax savings of up to $80,000.
- Now let’s say you have heirs that you’d like to help out. If you leave that same investment property worth $500K to your children, they can sell it when they inherit and never pay any capital gains tax on that sale. That’s because, under the 1031 exchange rules, their cost basis is the current fair market value. The gains on your initial investment of $100K aren’t factored in.
- A third way to benefit now from the 1031 exchange is to leverage it to climb the investment ladder. Using that same example, you might not have been able to afford to buy a $2 million property several years ago. But now you can use that $400,000 profit to put 20% down on a $2 million property. That’s quite a step up in your investment portfolio!
- Or, you could spread out that $400,000 and use it to put down payments on up to four different properties that you identified using the 45-day identification rule under the 1031 exchange. This is a great way to expand and diversify your real estate investment portfolio without spending an extra dime of your own money beyond your original $100K investment.
With home prices the way they are, many experts feel this is a great time to sell. If you’re in a position where you’ve been holding an investment property for at least a year, you owe it to yourself to look into doing a 1031 exchange. If you’re interested in finding out what your existing property might be worth or want to look at investing in Dallas-Fort Worth or even Belize, give us a call at American Real Estate Investments. We’d be happy to help any way we can!