Like other investment avenues, real estate is a sector where investors constantly seek new strategies and opportunities to enhance their investments. One such tactic that has gained traction is the 1031 exchange, a robust tax deferral tool.
Whether to upgrade and diversify their portfolios or simply because they wish to wash their hands of a problematic property, savvy investors have been using 1031 exchanges to increase their purchasing power when selling investment properties and purchasing new ones. One of the lesser-known features of this immensely beneficial tax code is the 200 (200%) rule.
In this article, I will peel away the layers of the 1031 exchange and elaborate on the 1031 exchange 200 rule so that you can understand when it’s appropriate and how to leverage it when executing a 1031 exchange. I’ll also explain why, if you think a 1031 exchange is the move for you, you should partner with a professional to help make the process a piece of cake!
1031 Exchanges: The Basics
Before digging into the 1031 exchange 200 rule, we’ll make sure you thoroughly understand how a 1031 exchange works. 1031 exchanges are a tax deferral rule outlined in section 1031 (hence the name) of the Internal Revenue Code.
When you sell an investment property, you are expected to pay capital gains taxes on the profits you made from the sale. For example, if you purchased a condo building in San Francisco for $1,000,000 in 2014, now valued at $1,750,000, you will be taxed anywhere from 10-20% on the $750,000 profit.
Let’s break it down further.
As you can see, even though you nearly doubled your money on paper by selling a property that’s gained substantial value since the original purchase, you will pay roughly 37.1% of your proceeds to the IRS as capital gains tax.
That’s over a third of your profit! Yikes!
Fortunately, the 1031 exchange process allows real estate investors like you to defer paying those capital gains taxes by taking the proceeds from the sale and reinvesting them into purchasing a new property. However, there are a few stipulations:
- The new property must be a “like-kind” property. In other words, it must be of equal or greater value than the original property and used for similar (investment) purposes.
- This new property must be identified within 45 days of the sale of the original property. This is called the 45-day rule.
- The 1031 exchange process must be completed within a 180-day window. This is called the 180-day rule.
- The 45-day rule and 180-day rule run together concurrently, meaning that if it took 30 days from the initial sale of the property to identify the new property, there are 150 days remaining to complete the 1031 exchange.
- The seller cannot pocket the proceeds from the original sale during the 1031 exchange process. Instead, the funds must be held by an intermediary.
As you can see, the 1031 exchange process can offer huge benefits to real estate investors looking to sell old properties and purchase new ones. However, investors must observe the stringent requirements and execute transactions within tightly scheduled timeframes when engaging in the 1031 exchange process.
What Is the 1031 Exchange 200 Rule, and How Can it Benefit You?
By now, you should have a relatively solid understanding of the 1031 exchange process in general. Now we can dig a little deeper and explore some of the nuances of this tool.
One such nuance is the 1031 exchange 200 Rule. Usually, when investors swap like-kind properties via a 1031 exchange, they do a 1:1 swap, exchanging one property for another.
However, while the 1031 exchange process is rigid, it offers some flexibility for investors regarding how many properties they can exchange for the original sale value. 1031 exchanges are generally used for trading up to more expensive properties, as the replacement property must be of equal or greater value.
But the 1031 exchange 200 rule allows investors to trade one property for multiple. With it, the investor can identify any number of properties for the exchange, so long as their aggregate value does not exceed 200% of the original property’s fair market value.
Let’s take a closer look. Let’s say the investor from earlier sells their original property for $1,750,000 (with an equal fair market value) because they want to diversify their real estate portfolio and exchange one property into multiple. To comply with the 1031 exchange 200 rule, the investor cannot exceed a maximum allowable value of $3,500,00 (200% of the original property’s fair market value); the investor purchases the following properties:
- Property A: Value = $1,200,000
- Property B: Value = $900,000
- Property C: Value = $400,000
Total Aggregate Value: $2,500,000
Because the total value of the new properties does not exceed 200% of the original property’s fair market value, our investor is compliant with the 1031 exchange 200% rule and may be able to defer their capital gains taxes.
This tactic can be a boon for investors as it enhances their flexibility, especially those who may wish to diversify their real estate portfolios with additional properties. It allows them to maintain the incredible tax advantages of the 1031 exchange.
However, it adds much more complexity to an already complicated and immutable process. Identifying one appropriate property in a traditional 1031 exchange within the tight window of deadlines is already challenging for many investors; adding more properties further complicates the process.
That’s why even the most experienced real estate investors should consult a professional before beginning the 1031 exchange process for guidance tailored to their unique financial situation to support your success.
Demystify Real Estate Investing With Canyon View Capital
Here at Canyon View Capital, we understand the many nuances of 1031 exchanges—like the 1031 exchange 200 rule. That’s because, for over 40 years, our professionals have managed multifamily real estate that is now valued at over $1 billion1 in aggregate.
Our team have participated and partnered along side many 1031 exchanges and we want to help investors like you enjoy the same kind of success. We are passionate about sharing what we know with our investors to help make the 1031 exchange process as seamless as possible.
But we don’t stop there. When you partner with CVC, you can rest easy knowing you have someone in your corner who genuinely cares. We want to educate you and help answer all your questions about multifamily investing. Whether you’re an experienced investor or simply testing the waters, we look forward to being a guiding light into your bright financial future.
Still Hazy on the Details of the 1031 Exchange 200 Rule?
Canyon View Capital Can Show You the Way! We will walk you through every step of your investment when using your 1031 exchange as a vehicle, and our staff will always answer your questions honestly, completely, and promptly. CVC will help you cut through the red tape, no matter how sticky it gets. For more on how you can invest using a 1031 exchange, contact Canyon View Capital.
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Gary Rauscher, President
When Gary joined CVC in 2007, he brought more than a decade of in-depth accounting and tax experience, first as a CPA, and later as the CFO for a venture capital fund. As President, Gary manages all property refinances, acquisitions, and dispositions. He works directly with banks, brokers, attorneys, and lenders to ensure a successful close for each CVC property. His knowledge of our funds’ complexity makes him a respected executive sounding board and an invaluable financial advisor.