A lighthearted parable tells the story of a man who planned to outrun the IRS by dying: Ten years ago, Bob bought a rental property at auction for $1. Its current value is $1 million. If Bob were to sell his property, he would owe taxes on $999,999. He decides he doesn’t want to do that, so instead of selling, he decides to do 1031 exchanges and then die, leaving the property to his three children. They sell the property, buy a Corvette, and get out of paying capital gains taxes.
While exchanges are rarely this simple, the story highlights a simple desire many of us have: to get out of paying taxes. Doing 1031 exchanges is a legal tax-deferral strategy that may be effective for real estate investors. But how should you go about this? And does it work better with small rental properties like Bob’s? Or is it better for larger buildings? Let’s review 1031 exchanges, talk about how they work with smaller buildings, and discuss which type of properties you can exchange with each other.
A Quick Review of 1031 Exchanges
Investopedia gives this great definition: “Broadly stated, a 1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another. Although most swaps are taxable as sales, if yours meets the requirements of 1031, you’ll either have no tax or limited tax due at the time of the exchange.”
Called 1031 in reference to its section of the tax code, these exchanges allow you to swap out your type of investment without realizing a capital gain. You can do 1031 exchanges over and over again, sometimes making a profit on each swap, but almost never having to pay tax until you sell for cash. The idea is that you should only have to pay one tax at the end of the process while you strive to grow your investment the whole time as you reinvest in real estate.
Sounds like a good deal, doesn’t it? Some of the benefits of 1031 exchanges include
- deferring capital gains taxes,
- keeping your money potentially growing for you, and
- providing an exit strategy for any highly appreciated equity that may help eliminate the hassles of tenants.
Can You Do 1031 Exchanges with Smaller Buildings?
The short answer? Yes!
The longer answer? Only business properties (not personal residences) are eligible for the 1031 treatment. That doesn’t mean you can only exchange large apartment complexes, though. While it’s less common to do 1031 exchanges with smaller buildings, there’s no reason you can’t apply the same principles to small buildings as you can to larger ones.
Larry Light, an investment advisor, gives a good example: Let’s say you have a vacation home, but you want to sell it and buy a new one that’s closer to your primary residence. It’ll take some planning (and there are stipulations, of course), but you can use a 1031 exchange here.
“The most important step is to rent the vacation place out for at least 14 days annually for two years, back to back,” Light says. “To the IRS, you have a business asset. . . . Find the substitute property within 45 days of selling the previous real estate. Then purchase the new property within 180 days of the sale.”
So yes, you can do 1031 exchanges with smaller buildings. You just have to be using them for investment purposes. But can you exchange smaller buildings for larger ones and vice versa?
Making Like-Kind Exchanges
IRS Section 1031 stipulates that these exchanges are like-kind properties. At first glance, that stipulation may sound like you have to exchange a restaurant for a restaurant or a house for a house. But it’s actually much more liberal than that.
All “like-kind” means is that both properties must have an investment or business purpose. So you can exchange an orchard for a row of townhomes or a boutique store for a piece of raw land. As long as both properties have business or investment purposes, it works.
That being said, for 1031s to be most helpful for you, you’ll want to make sure the two properties are close in value. For example, if the mortgage on your first property is $2 million, and the mortgage on your second property is $1.8 million, you’ll end up with $200,000 cash. This cash is known as “boot” and will generally be taxed as a capital gain. The closer the properties are in value, the more money will stay in your investment and keep potentially growing for you.
1031 exchanges allow you to defer taxes and put your money to work for you. They may be a great option for you! Are these exchanges better for smaller or larger buildings? As long as your properties are intended for business or investment purposes and they don’t differ in value too much, the size of the building doesn’t really matter. Learn more about how 1031 exchanges could potentially be a great strategy for your portfolio.
Securities offered through Emerson Equity LLC, Member FINRA, SIPC. Emerson Equity LLC and NBPC are not affiliated. All investing involves risk. Past performance is not indicative of future results. Speak to your tax and/or financial professional prior to investing.