Raise your hand if you would like to use an investment vehicle that allows you to grow your real estate portfolio by transferring equity from one property to another tax-free!!!!
Well look no further… it is the 1031 exchange.
Ok, I confess, the 1031 exchange is not the only way to tap equity tax free… You can use a cash-out refi or a heloc as well. Those option are cool because you can retain your original property while gaining access to the equity… but I digress…
Let us assume you are ready to move on from your property and you want to sell it but do not want to pay taxes on the equity gain. A great strategy is to set up a 1031 exchange.
1031 Exchanges can feel a little complicated at first and you may not be at that stage yet but it is something to know about.
The first step is to talk about 1031 exchanges and then we can look at the REVERSE 1031 exchange… (If you know all this then feel free to skip to the next section).
To be clear, I do not run or operate a 1031 exchange company or claim to be the highest authority in this area, but I will try to break it down into clear terms.
A 1031 is essentially a tax saving strategy for real estate investors like you.
The way it works is that you can sell a property and place the equity into an escrow account managed by a 1031 exchange. This money cannot be handled by you or your accounts. The sale proceeds need be transferred directly to your 1031 on completion of sale and are used for your next purchase
Therefore, You NEED TO SET UP YOUR 1031 EXCHANGE BEFORE YOU SELL YOUR PROPERTY. (But don’t worry there are a ton of companies out there that specialize in the details of this process)
Knowing the terms of a 1031 exchange will be helpful:
1031 exchange: The name actually comes from the IRC (Internal Revenue Code) section 1031 (https://www.irs.gov/pub/irs-drop/rp-03-39.pdf)
“Relinquished” property: The property you are selling
“Replacement” property: The property you are buying
Exchanger/Exchangor: is the person or entity completing the exchange
Qualified Intermediary (QI) or Facilitator: the party that handles the exchange transaction
Exchange Accommodation Titleholder (EAT): this is for a “reverse exchange” and will be discussed later….
The first step is to sell/“relinquish” a property.
The next step is to purchase your “replacement” property.
The equity from your 1031 exchange is used for the down payment of this next property.
In fact, the money in the 1031 can actually be split up among multiple purchases.
The key is to follow the below steps:
- Set up a 1031 Tax deferred exchange
- Sell your property “the relinquished” property
- Purchase a “replacement” property and meet the below criteria:
- The “replacement property” value must be greater in value than your “relinquished” “sold” property
- The purchase property must be a “like kind” property. Essentially an investment property to investment property exchange. (You cannot sell your primary home using a 1031 exchange to purchase your next STR.)
- You have 45 days after completing the sale of your “relinquished” property to “identify” a replace property (aka the identification window) and 180 days (6 months to complete the exchange.)
If you can complete these steps… Then BOOM you have exchanged the EQUITY from one property to another property tax free (even California recognizes this process, haha).
Note: You can use the equity from your “relinquished” property for up to three other “replacement” properties.
If you purchased property A in the Mammoth Lakes for 500k in 2016 and it is now worth 1.1 million you can sell that property and place the equity, 600k, into a 1031 exchange.
That 600k, can then be used to purchase THREE 1 million-dollar properties with 20% down via traditional investment loans. If you are close to your DTI (debt-to-income) limit you can even consider a DSCR loan. It is a pretty amazing investment vehicle.
Please note: I left out the real estate agent fees, closing costs, 1031 exchange fees etc to keep the math simple.
So now let’s rewind it back and go with the “Reverse 1031” Exchange.
This option is a little more complicated but is also pretty awesome in today’s hot market.
In this scenario, you identify a property that you must have.
You place the offer and miraculously get the property under contract….
But now you realize the deal would better if you could transfer the equity from some other properties into this new property….
That is where the “reverse 1031” comes into play.
The “reverse” allows you to identify the “replacement” property first and then you have 45 days to determine the property you will sell/“relinquish” and 180 days to complete that transaction….
It is the exact opposite of a 1031 exchange
(selling first and then using the money in the exchange to purchase a new property.)
So, to write it out…. Let’s look at the steps to a “Reverse 1031” exchange.
- Set up a Reverse 1031 Tax Exchange
- Create an Exchange Accommodation Titleholder (EAT)
- Plan for an “exchange first” or “exchange last” transaction
- Purchase your “replacement property” – the value must be greater than your “relinquished” properties
- Sell the “relinquished” property. The relinquished property must be identified in 45 days and the sale must be completed within 180 days.
- In an “exchange first” scenario: The EAT “purchases” the “relinquished” property/properties first from you. You transfer the title to the EAT and cover the additional estimated equity from your reserves. Once a buyer completes the purchase of the “relinquished” property the EAT transfers title to the buyer and the net sale proceeds are transferred to you to pay off any debts (ie the mortgage and equity “cost” covered by you.
- In an “exchange last” scenario: The “replacement” property is held by the EAT and a buyer can be identified 45 days after closing. Once the buyer completes the purchase of the “relinquished” property, the proceeds are added to the exchange to pay back the EAT for the purchase of the “replacement” property aka you.
Ok, so those steps might have been a little complicated…
To break down, there are two types of “reverse 1031” exchanges and the downside to both is that you need to have cash or access to cash to make them work. The benefit is that you can move quickly in a seller’s market to purchase a property and work the exchange out on the backside.
The “Exchange Last” option: means that you purchase the “replacement” property with cash and then transfer the property to the EAT (Exchange Accommodation Titleholder) by transferring title. The reason for purchasing in cash is that most lenders will not close straight into an EAT.
The “Exchange First” option: means that you sell/“transfer title” of the “relinquished” property to the EAT and the EAT will lease the property back to you to cover all costs. The EAT will only cover the existing mortgage debt so you will then need fund the estimated equity portion of the purchase price of the “relinquished” property with your own funds.
In general, the “exchange first” option allows you to use less cash than the “exchange last” option.
For the “replacement” property portion of the “reverse” exchange everything works like a normal 1031 and you can close in your name.
The funds from the EAT (which purchased your “relinquished” property) will be used for the down on the purchase “replacement” property just like a normal 1031 exchange. Then when you sell the “relinquished” property to a 3rd party you will pay the EAT back and then yourself for the equity you covered.
It sounds a little complicated but honestly there are great companies out there to guide you through the process.
The main point of the post today was to provide some exposure to 1031 exchanges, as well as, the less talked about “reverse 1031” exchange. They are viable options to allow you to grow your portfolio. Good luck out there and have a great week.
Enjoy your Journey to Financial Freedom