A 1031 Exchange can help you defer taxes and build wealth for retirement – but what do you do when it’s time to finally sell?
Section 1031 of the tax code allows for the deferral of capital gains taxes and depreciation recapture from the sale of real property if the seller exchanges it for a property of like kind within 180 days (along with meeting other requirements). Because this allows you to reinvest your gains in the replacement property, 1031 helps investors purchase more expensive properties and build more wealth over time, making it a great strategy for retirement.
When it’s time to retire, you can sell and use the proceeds to fund your retirement. However, when you do, you’ll have to pay the capital gains taxes you previously deferred through your exchange(s).
That’s why it’s important to understand the different ways to incorporate 1031 into your retirement plans, because depending on the type of property you own, your liquidity and income needs, and how active a role you wish to take in your portfolio’s management, there are different strategies for making the most of your real estate investments and the tax incentives available to you. Here are a few of the most likely scenarios and how 1031 can be used to your benefit.
Exit strategies for 1031 upon retirement
Many people have the bulk of their personal wealth in real estate investments. In order to retire, they often need to sell those assets to have steady access to the capital. When selling your exchange property, you’ll have to pay the capital gains taxes deferred through your exchange(s). In order to avoid overpaying, a proper exit strategy is needed to limit your potential tax liability.
One thing to keep in mind is the time frame. Capital gains tax rates can change depending on which political party is in power, so it’s a good idea to consult with a tax professional to decide on when you’re going to sell. Electing to sell a property now, as opposed to a year from now, could make a big difference when it comes time to pay the associated taxes.
Capital gains rates also depend upon how long you hold the property. If you initiate a sale on property acquired through a 1031 Exchange but haven’t held the property for more than a year, you could be taxed at the ordinary income rate as opposed to the long-term capital gains rate.
You’ll also need to factor in depreciation recapture and Net Investment Income Tax to your ultimate cost to sell, which is why it’s important to consult with professionals to fully understand your tax consequences. Strategies such as tax loss harvesting can limit your liability, as can reinvesting the proceeds in another tax-advantaged investment such as an Opportunity Fund. Not everyone can take advantage of these strategies, but it’s worth investigating to see if they’re right for you.
Using 1031 when selling a small business for retirement
If you run a small business, retirement may involve stepping away from or selling that business, and if you own the property where your business operates, it may no longer make sense to hold onto it. In that case, it’s time to sell, but that doesn’t mean your 1031 journey is done.
If you don’t have an immediate need for the capital from your property sale, you could reinvest in a different type of property through a like-kind exchange. Section 1031 has a very broad definition of “like kind,” meaning even if you’re selling a retail storefront or warehouse, you can exchange into a residential property or something more passive.
Passive investment properties can include triple-net leases, where more of the costs and responsibilities are passed onto the tenant, and Delaware Statutory Trusts, where a professional property manager oversees a broad portfolio of investments. By exchanging into one of these investments, you’ll be spending less time managing the property and more time enjoying your retirement while enjoying the returns from your investment.
You can read our full 1031 small business guide here to learn more about how small business owners can take advantage of 1031.
Single-family rental properties and vacation homes: downsizing for retirement
While 1031 is very popular among those who own commercial properties, it can also be used for residential properties. In fact, some highly-specific situations, such as when the property is a duplex and the Exchanger lives in one unit and rents the other out, or when the property is a vacation home that is also available for rent, that may allow the Exchanger to personally use the exchange properties.
Single-family rental homes can be ultimately sold in order to use the proceeds for retirement expenses, and the Exchanger would essentially cash out and pay the taxes that had been deferred through prior 1031 exchanges. However, there are ways in which residential properties acquired through a 1031 exchange can be used as a place to live when you retire.
Some Exchangers may want to sell their primary residence and downsize to a smaller home or relocate to a more desirable climate. Even if these properties were purchased via a 1031 exchange, they do not have to sell them in order to convert it to a primary residence.
Once this home is used as a primary residence for at least two of the preceding five years, the Exchanger becomes eligible to take advantage of a different set of tax rules. This may not exclude all of the gains that had been deferred in the prior 1031 exchanges, but advance planning with a skilled tax adviser can maximize the potential tax savings.
1031 and estate planning
Remember that with 1031, you’re deferring taxes, not eliminating them, so when you eventually sell the property, you’ll still have to pay those taxes at the current rate. But if you don’t sell the property until your death, your heirs would not be responsible for the taxes on any gain that you deferred.
When you leave a property to your heirs in your will, they receive the property with a step up in basis. This means that the basis for the property is adjusted to the fair market value at the time of your death. If you purchased a property at $100,000 and held it until your death, when it was worth $1,000,000, your heirs would have a basis of $1,000,000 and would only pay taxes on any gains above the initial value of $1,000,000.
In this way, 1031 can maximize how much you’re able to leave behind for future generations. The key is to understand your financial needs, get the right financial advice to plan for your retirement and death, and keep abreast of changes to laws that might affect your plans.
The Biden Administration has proposed a cap on the amount of capital gains taxes that can be deferred through 1031 exchanges, and has also suggested eliminating the step up in basis. This would potentially mean the end of this strategy for many people, so it’s important to understand the current laws to make sure you don’t need to alter your investment strategy. You should always consult with your tax adviser to understand your specific liabilities before deciding to participate in a 1031 exchange.
Finding the right QI for your exchange
You may plan to perform one exchange or multiple exchanges; you may be exchanging from an operating business into a triple-net lease or a DST; you may be selling a multifamily apartment building and using the proceeds for retirement expenses; you may plan to live in a single-family investment home before selling it; and you may plan to hold onto your investment property until your death. Regardless of which of these scenarios applies, you need a Qualified Intermediary for each exchange you perform.
JTC has more than 30 years of experience as a QI, with tens of thousands of successful transactions. Our Client Services team is supported by an award-winning cloud based platform that offers 24/7 access to exchange information, and we have experts in all manner of exchange scenarios. No matter how complicated your exchange or how intricate your retirement strategy, JTC can help.
Learn more about 1031 Exchanges by visiting our 1031 Exchange Guide.