Defer Taxes—Not Profits—With a 1031 Exchange

Posted by Residential Capital Partners on Apr 23, 2021 11:31:31 AM

The purpose of flipping houses — or any property — is to realize a profit. Period. From the minute you secure a property with a hard money loan, your focus is turning your property into a tidy profit that you can take to the bank.

Novice flippers normally have their eyes on this prize. They have worked hard to find the right property. They’ve successfully rehabbed and sold a property or two. They’ve developed relationships in the business from sound contractors to hard money lenders, both of whom can move swiftly at their direction to help them realize their goal – profits and more of them.

But once a novice flipper begins moving up the scale of their craft, their eyes naturally drift to more sophisticated ways to realize and protect their profits as they wield their trade. One of these handy tools of sophistication is the 1031 Exchange.

What Is a Section 1031 Exchange?

Section 1031 is an IRS code that allows you to defer paying capital gains on an investment property if you do a like-kind” exchange of one property for another.

For example, let’s say you buy a property for $100,000, improve it, and the value rises to $200,000. If you simply sell, you’ll be taxed on your gain at your ordinary income level. But if you trade the property for another property of like value, you can defer your taxes until you sell the exchanged property.

The Rehab to Rental Strategy

The novice turned proficient or expert rehab professional can take the opportunity to turn the 1031 Exchange example above into a powerful wealth building strategy. Upon selling the improved property for $200,000, the rehab professional will immediately begin looking for a property of like-kind or similar value to trade into in order to avoid paying ordinary income tax rates on the gain from sale.

Let’s assume the original property purchased for $100,000 had a repair budget of $25,000 for an all-in basis of $125,000. Thus, the gain on sale from a $200,000 sales price equals $75,000. If the rehab professional can find a $200,000 property that has already been improved and has a tenant in place, then he/she can buy that house with a $75,000 down payment while securing a long-term rental loan with which to hold the property long-term.

Here’s how it breaks down:

  1. The rehabber has parlayed a $75,000 gain into a long-term rental property tax-free.
  1. The rehabber has secured an immediate long-term rental income stream that will only get better over time as they pay off the debt.
  1. The rehabber has deferred taxes for the duration of the rental property hold period.

Taking this example a little bit further, let’s assume the rehabber secures the long-term rental loan, begins managing the rental property, and starts paying down the 62% loan-to-value (LTV) rental loan. A year goes by, the market improves, and the rehabber has reason to believe their property has increased in value to $250,000, making the loan to value now 50% ($125,000 loan / $250,000 value).

  1. The rehabber can secure a cash-out refinance up to 75% of the value of house. In other words, the rehabber can pull out $62,500 of tax deferred profit to use in his fix-and-flip business while continuing to cash flow a sustainable rental property.

What Are the Advantages?

The immediate advantage is clear – deferred taxes on your next flip while securing long-term rental income with which to build wealth. But the advantages become even more clear if you continue employing the strategy over time. It is akin to the power of compounding interest—employing this strategy over time will unlock more and more value as you continue to build your portfolio.

What’s the Catch?

The catch is pretty evident: you’re a long-term holder of this rental property, because once you decide to sell, you’ve got to pay the piper. But, here’s the good news. Paying the IRS means you turned a profit!

Important Things You Need to Know:

If you’re interested in doing a 1031 Exchange, you need to remember:

  • Employ an Intermediary. It’s best to use an intermediary who has experience with handling 1031 Exchanges.
  • Know the Rules. You can only employ a 1031 Exchange on investment or business property, not personal property.
  • Hit the Ground Running. After your sale, you have 45 calendar days to identify in writing and deliver to your intermediary up to three potential replacement properties. (If you’re a savvy flipper, you may have your next prospects lined up before you sell your latest flip.)
  • Hire an Expert. Before you consider a 1031 Exchange, consult your CPA. It’s best to use a CPA who has handled flips before and is experienced with 1031 Exchanges, because the laws change from time to time (most recently in 2017).

What’s the Drawback?

A 1031 Exchange can be worth pursuing — but you have to be aware of a few things.

  • Regulatory Hassles. Doing a 1031 Exchange requires paperwork, meeting with your CPA and finding a qualified intermediary. In addition, you have to work within the time frame required by the IRS.
  • Timing is Crucial. Your intermediary must purchase the replacement property within 180 calendar days of your original closing—or the extension date of the tax year in which your property was sold—whichever is earlier.
  • Tax Rates may Change. How high will capital gains taxes be in 2030 or 2040? No one knows. In 2013, capital gains rose to 20% and 3.8% Medicare was added onto certain gains. Unexpected increases make an impact when it comes time to sell.

The Bottom Line

If flipping is only an occasional side venture for you, a 1031 Exchange may not be appropriate. But if you flip frequently, or if you’re interested in amassing a sizeable portfolio of properties, doing a 1031 Exchange can be a powerful way to help grow your long-term wealth.

Explore Your Options with Residential Capital Partners

At Residential Capital Partners, we understand your world. Unlike other private lenders, we lend 100% up to 70% of your property’s ARV on short-term fix-and-flip loans. We also crafted a medium-term bridge rental program and a long-term rental loan program for our customers. Our terms are straight-forward and our processes are simple. With our tremendous depth of experience, we’re able to answer questions on 1031 Exchanges and other strategies for maximizing your profits.

Apply today or update your file with Residential Capital Partners. Once you have been approved, we can move you through the approval process so you can close within 14 days.

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Topics: Fix-and-Flip Financing Tips