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Summary
Often time investors default to a normal 1031 exchange. However, we often hear this is inflexible and causes panic.
A traditional 1031 exchange, also known as a like-kind exchange, allows real estate investors to defer paying taxes on the sale of a property by reinvesting the proceeds into another property. While this can be a useful tool for investors, there are several downsides to consider:
- Limited Timeframe: Investors have only 45 days from the sale of their property to identify potential replacement properties and just 180 days to complete the purchase. This can be a tight timeline, especially in competitive markets.
- Limited Flexibility: The IRS has strict rules about what types of properties qualify for a 1031 exchange, limiting an investor's ability to diversify their portfolio or invest in other asset classes.
- Higher Purchase Price: In order to fully defer taxes, an investor must purchase a replacement property of equal or greater value than the property sold. This can limit an investor's ability to downsize or take profits from a sale.
- Administrative Burden: Completing a 1031 exchange requires careful planning and coordination with multiple parties
What is a useful alternative?
A Lazy 1031 exchange is a tax strategy used by real estate investors to defer taxes on the sale of a rental property. This strategy involves selling one rental property at a gain and then, in the same year, placing a second property in service. The second property must have an equal or higher basis than the first property to make the math work. Also - this will only work in years in which bonus depreciation is allowable.
A Cost Segregation study is then performed, and 60% depreciation is claimed in 2023. Since both activities are Passive Activities under IRC 469, the gain and the loss will offset each other.
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How Does a Lazy 1031 Exchange Work?
The Lazy 1031 exchange works by taking advantage of two tax strategies: the 1031 exchange and cost segregation. Here's how it works:
- Sell a rental property at a gain. Gain = sales prices less adjusted basis of the property. This strategy will NOT work for the sale of a primary residence.
- Purchase a second rental property with an equal or higher basis. Remember, basis is building only, so you must subtract the land value.
- Perform a cost segregation study on the second property.
- Claim 60% bonus depreciation under IRC 168k in 2024.
- Offset the gain from the sale of the first property with the loss from the depreciation of the second property.
How does this work and why do some CPAs not understand this?
Since most real estate investors are considered Passive investors (IRC 469) meaning they are not real estate professionals, they report their passive activities on Form 8582. Your passives losses accumulate on this form and they are offset by other passive income.
When you dispose of a property that was a "passive activity", the gain is considered a "passive activity gain". By statute, this gain MUST net against passive activity losses from ANY property (this is the common misconception).
Gains from passive activity sales net against passive activity losses from ANY source!
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Benefits of a Lazy 1031 Exchange
There are several benefits to using a Lazy 1031 exchange as a tax strategy:
- Tax Deferral -similar to a traditional 1031 exchange, this will allow you to defer capital gains and depreciation recapture taxes on the sale of a property.
- Flexibility - unlike a traditional 1031, you do NOT have to identify a property or involve an intermediary within 180 days. In fact, you could pull the the Lazy 1031 Exchange strategy off up until the last day of the same tax year!
- More Cash - depending on your equity in the original property, you may end up with significantly more cash in your pocket. Check out the Anomaly Lazy 1031 Exchange Calculator!
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Conclusion
A Lazy 1031 exchange is a tax strategy that can help real estate investors defer taxes on the sale of their rental properties while generating income from new rental properties. In years of Bonus Depreciation, this strategy provides more flexibility over a Traditional 1031 exchange.
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FAQs
The Concept Of 'Lazy' 1031 Exchanges
Essentially, a "lazy" exchange involves using the depreciation from a new investment to help offset the capital gains from a sold property. The new investment could include passive investments in real estate syndications, where depreciation may be accelerated.
What is the 95% rule in 1031 exchange? ›
The 95% rule says that a taxpayer can identify more than three properties with a total value that is more than 200% of the value of the relinquished property, but only if the taxpayer acquires at least 95% of the value of the properties that he identifies.
What is the 2 year rule for 1031 exchanges? ›
This rule stipulates that you must hold onto your new property for at least 2 years after the exchange. Its purpose is to prevent you from quickly flipping properties, as the primary aim of a 1031 exchange is a long-term investment, not short-term profit.
What is the negative about 1031 exchange? ›
Deferral, Not Elimination, of Tax- While a 1031 exchange allows investors to defer capital gains tax, it doesn't eliminate it. If the replacement property is eventually sold (and not exchanged again), the deferred taxes will come due.
When should you avoid a 1031 exchange? ›
The two most common situations we encounter that are ineligible for exchange are the sale of a primary residence and “flippers.” Both are excluded for the same reason: In order to be eligible for a 1031 exchange, the relinquished property must have been held for productivity in a trade or business or for investment.
Can you lose money in a 1031 exchange? ›
Investors who lose their money when an exchange company fails not only risk losing all of their cash, but if they have entered into a contract to buy the replacement property, they could be subject to a lawsuit for failure to acquire the property.
What disqualifies a 1031 exchange? ›
A 1031 exchange can be disqualified if the property being exchanged is not used for business or investment purposes, if the exchange is not completed within the specified timelines, or if the exchange does not meet IRS regulations.
What is the 100% rule for 1031 exchange? ›
The strict 1031 exchange rules require the new investment property to be of equal or greater value than the property being sold. Additionally, for a full tax deferral, the entire proceeds of the sale must be used to purchase the second property.
What voids a 1031 exchange? ›
If a seller cannot meet the deadlines for the 45-day identification period or the 180-day exchange period, the 1031 exchange is considered a failure.
How soon after a 1031 exchange can you sell? ›
While there are no definitive rules on a holding period for a 1031 exchange property, it has made rulings indicating that a holding period of two years has been considered sufficient in order to meet the qualified use test.
1031 exchanges are not limited to a one-for-one property swap. They offer the flexibility to exchange one property for several others, or vice versa, as long as certain conditions are met.
Which of the following would disqualify a property from being used in a 1031 exchange? ›
Primary residences: A 1031 exchange is specifically intended for investment or business properties. Personal properties are not eligible. Vacation homes: Vacation homes generally do not qualify if used for personal reasons.
What is better than a 1031 exchange? ›
The Deferred Sales Trust is an effective 1031 exchange alternative to help business and real estate owners sell their assets and defer capital gains tax.
Is it better to pay capital gains tax or do a 1031 exchange? ›
Benefits of a 1031 Exchange
Defer Capital Gains Tax: A 1031 exchange allows you to defer capital gains taxes, which can be substantial. This deferral can free up more capital for reinvestment, enabling you to acquire larger or more lucrative properties.
Do you eventually pay taxes on a 1031 exchange? ›
It's important to remember that a 1031 exchange only delays taxes; it doesn't eliminate them. A tax bill eventually comes due if you sell the replacement property and don't reinvest the proceeds into a new property with another 1031 exchange.
What can I do instead of a 1031 exchange? ›
Here are a few alternatives to 1031 exchanges to consider:
- Opportunity Zones. Opportunity Zones are designated as economically distressed areas in which investors can receive tax benefits for real estate investments. ...
- Delaware Statutory Trusts (DSTs). ...
- Installment Sales. ...
- Paying Capital Gains Taxes. ...
- 721 Exchanges.
Unfortunately, if a taxpayer is not able to purchase new property to successfully complete the 1031 Exchange, the taxes associated with the sale of their investment property will be due.
What is a 1031 exchange for dummies? ›
Section 1031 of the IRC defines a 1031 exchange as when you exchange real property used for business or held as an investment solely for another business or investment property that is the same type or “like-kind.” As the code makes clear, real properties are generally viewed to be like-kind, and the seller of a ...
Which type of property does not qualify for 1031 exchange? ›
Property that does not qualify includes but is not limited to a primary residence, a second home, flip properties, or a property held in inventory for sale. Recent changes to tax law disallow personal property (artwork, boats, etc.) as valid property in a 1031 Exchange at the federal level.
