A Tax-Smart Strategy for Investment Real Estate: 1031 Real Estate Exchange

The unexpected keeps happening in 2020. And that’s especially true in the world of real estate, where some areas and segments are booming while others are floundering. And so this is a good time to reassess if your investment real estate is working for you or if perhaps some changes are in order. Say you own 100 acres of farmland or an aging apartment building in the city, worth much more than you paid but now producing less income after all expenses. What to do? Consider a 1031 Real Estate Exchange, the rules for which I described in this previous blog post.

A 1031 exchange lets you sell property you no longer want or need, defer taxes on the profit, and then invest in real estate that makes more sense for you. This strategy is especially advantageous if you own investment property that is not likely to appreciate as much in the future and has rising maintenance and renovation costs. Here’s an example of how this can work:

Let’s say Mary and Bill are in their 50s, with a primary residence in Seattle plus two rental houses in Renton, WA. Both rentals are leased at below-market rates — $1,800 a month each (net $1,500) — because they’re in need of major updating and repairs. Estimates are that each house can sell for $450,000, a big gain from the $100,000 they paid.

Problem: Bill and Mary want more income for their retirement years, a nice get-away from Seattle, and to not worry about renovating old rental houses.

Solution: With the help of a property manager, they look nationally and find recently built homes in vacation destination Taos, New Mexico priced at $400,000 each. They hire an intermediary to do a 1031 Exchange, and then sell their two houses in Renton for a total of $900,000 tax-deferred. The net proceeds from the Renton sale, roughly $800,000, are then invested in two newer houses in Taos. Each of those is then leased, netting $2,000 a month on average.

Result: A potential 33% increase in Bill and Mary’s net monthly rental income: to $4,000 (up from $3,000). And they would then own newer rental houses that will require little maintenance.

The above is hypothetical, of course, and the devil’s always in the details. But if you do own investment or business real estate that is not working for you, it’s worth exploring a 1031 Real Estate Exchange. Our advice, as always, is that an exchange should be done in context of an overall wealth plan that takes into account where you are now and where you want to be years from now. Without a wealth plan in place, you risk selling yourself short (pun intended).