1031 for all: Unlocking the power of tax-deferred real estate investing - by Ryan Vassar

There is a misconception that only the ultra-wealthy can leverage the IRS tax code to reduce their taxes. One of the most powerful and accessible tools available to real estate investors is the 1031 exchange, a provision under §1031 of the Internal Revenue Code (IRC).

Whether you own a 25-story apartment complex or a single-family rental home, the 1031 exchange allows for the deferral of capital gains taxes when reinvesting proceeds from the sale of one investment property into another.

A 1031 exchange permits the deferral of capital gains tax when a taxpayer sells investment property and reinvests the proceeds into another property of like-kind, which must also be held for investment or business use.

This provision is widely used — not just by large institutions but by small- and mid-sized investors seeking to grow their portfolios while minimizing tax exposure.

When an investment property is sold without a 1031 exchange, the resulting tax burden can be significant due to multiple layers of taxation. First, the federal capital gains tax is 15% or 20%, depending on your income. Also, there is a net investment income tax of 3.8% for taxpayers earning over $200,000. Additionally, if depreciation was taken on the property, the IRS “recaptures” a portion of the depreciation through taxation at 25%. Finally, state capital gains taxes are applied which vary from state to state. When aggregated, these taxes can total up to 35% of the total gain, significantly reducing the amount of capital available for reinvestment.

Investors pursue exchanges for a variety of strategic reasons such as transitioning into higher yielding properties, consolidating or diversifying assets, reducing management burdens, or estate planning. The 1031 exchange enables investors to reallocate capital efficiently without the tax erosion associated with a sale.

A homeowner with an accessory rental unit may be eligible to defer taxes on the portion of the property they rent. If that individual is selling their home, a 1031 exchange allows the seller to reinvest a portion of the proceeds into like-kind property without paying capital gains tax. In some cases, the 1031 exchange can be combined with IRC §121 which permits exclusion from capital gains on the sale of a primary residence.

In 2008, the IRS provided guidance to make a vacation/second home eligible for a 1031 exchange. Under IRS Rev. Proc. 2008-16, the IRS will not challenge a 1031 exchange for a vacation/second home if certain requirements are met.

The property must be owned for at least two years prior to the exchange. It must be rented at fair market value for at least 14 days in each of the two prior years. The owner’s personal use must not exceed the greater of 14 days or 10% of the days rented.

After the exchange, the new property must also be rented for at least 14 days per year and abide by the personal use standards set out by the IRS. Thereafter, it may be converted to entirely personal use.

While the 1031 exchange is a powerful tool, it is governed by strict regulations. An exchange must be completed within 180 days. “Like-kind” property is all real estate so long as it is held for investment or business purposes. The investor cannot take receipt of sale proceeds and must engage a Qualified Intermediary (QI) prior to the sale to hold exchange funds.

While these are some of the key rules, there are many regulations to consider. A QI plays a critical role in ensuring IRS compliance and a smooth process. With the help of your attorney and CPA, a QI can guide you through the complex 1031 rules.

The 1031 exchange is not a tax loophole for the wealthy. It is a legal, strategic, and highly effective method for any investor to grow and reposition real estate assets while deferring taxes.

Whether you are a landlord, an investor, or planning for retirement, a 1031 exchange may be the key to unlocking greater investment potential.

Before proceeding, consult with your advisors to ensure your exchange complies with IRS regulations and aligns with your broader financial goals.

IPX1031 is the industry leader in facilitating 1031 exchanges nationwide. With over 30 years of experience and the backing of Fidelity National Financial, IPX1031 provides comprehensive support to ensure secure, IRS-compliant exchanges for investors of all sizes.

For more information, visit www.ipx1031.com.

Ryan Vassar, Esq., is vice president of Investment Property Exchange Services, Inc. (IPX1031), Westbury/Riverhead, N.Y.