– The “lazy 1031 exchange” strategy is a simple and hassle-free way to avoid capital gains taxes in real estate.
– A standard 1031 exchange allows investors to defer capital gains taxes by swapping one similar asset for another.
– However, 1031 exchanges come with drawbacks and strict timelines, requiring the use of a qualified intermediary and settling on a replacement property within a certain timeframe.
– The lazy 1031 exchange strategy can be used when investing passively in real estate syndications.
– By investing in a new real estate syndication, the upfront losses on paper can offset any capital gains from a previous investment.
– This strategy takes advantage of accelerated depreciation write-offs from cost segregation studies and bonus depreciation.
– Cost segregation studies allow owners to reclassify parts of a building for shorter depreciation timelines, resulting in more on-paper losses.
– Bonus depreciation, allowed under the Tax Cuts and Jobs Act of 2017, provides additional depreciation benefits.
– Reinvesting proceeds from one passive real estate investment to another allows for indefinite tax deferral.
– This strategy avoids the hassles of direct real estate investing and allows for simple and hassle-free tax strategies.
– The author emphasizes the importance of simplicity and time-saving strategies in their own investing approach.
Real estate offers plenty of strategies to avoid taxes. However, many require you to jump through hoops, hire third parties to help you, and otherwise make your life harder.
This is why I use the “lazy 1031 exchange” strategy: no hoops, no hassles, no hiring custodians.
But before explaining what a “lazy 1031” is, let’s make sure we’re all on the same page about how standard 1031 exchanges work.
Refresher: 1031 Exchanges
Section 1031 of the IRS tax code allows investors to do a “like-kind exchange,” swapping one similar asset for another. When you sell a rental property and use the proceeds to buy another, you defer capital gains taxes on the sold property.
Using 1031 exchanges, you can buy increasingly larger, better-cash-flowing properties without ever paying capital gains taxes on any of the profits. Actually, you have to trade up: The new property must have a greater value than the sold property.
Of course, you have to pay the piper eventually. When you sell the last property in the chain, you owe full capital gains taxes on all accrued profits. Or you could just hold it until you die and let the cost basis reset. But I digress.
That all sounds great in theory, but 1031 exchanges come with drawbacks and headaches. To begin with, you have to comply with strict timelines. Within 45 days of selling the old property, you have to declare the new one you intend to buy as a replacement. And you have to actually settle on it within 180 days of selling the last property.
You also need to hire a “qualified intermediary” to hold your proceeds from the prior property sale. It costs hundreds of dollars, perhaps more, even if you use your bank as the qualified intermediary.
Don’t get me wrong—1031 exchanges work. They help you avoid capital gains taxes when selling income properties. But they also come with red tape—and in most cases, they’re only practical to use with active real estate investments.
What Is a Lazy 1031 Exchange?
When you invest passively in real estate syndications, you get a huge tax write-off in the first few years of ownership. More on the mechanics of that shortly, but for now, just take my word for it.
You can use that on-paper loss to offset other passive income or capital gains on investments. Like, say, the profits when a past real estate investment sells.
See where this is going?
Imagine you invested $50,000 in a real estate syndication deal three years ago. This year, the sponsor sells the property, and you walk away with a $30,000 profit on top of the cash flow you earned over the last three years.
You could pay capital gains taxes on that $30,000 profit. Or you could simply invest in a new real estate syndication at some point this year.
By investing in a new group real estate deal, the upfront losses you show on paper then offset that $30,000 gain. The net result: You pay no capital gains taxes, even though you pocketed a huge profit, plus some cash flow on both properties this year.
How Accelerated Depreciation Works
You can take advantage of fast depreciation write-offs from two sources: cost segregation studies and bonus depreciation.
Cost segregation studies
When a syndication sponsor buys a large commercial property, such as an apartment complex, they typically hire a firm to conduct a cost segregation study. They use that to reclassify as much of the building as possible into other tax categories with shorter depreciation timelines.
The IRS lets investors depreciate commercial buildings over 39 years and residential buildings over 27.5 years. In other words, owners can write off 1/39th of the building value each year for depreciation. But if the owner reclassifies parts of the building as personal property, they can depreciate them over just five or seven years. So, instead of deducting for 1/39th of the value, they can deduct one-fifth of the value each year.
The upshot is that for the first five years or so, you can show a lot of on-paper losses on your tax return from depreciation.
The Tax Cuts and Jobs Act of 2017 allows investors to take even more depreciation than usual—for a little while, anyway.
Passive Real Estate Investments
By continuing to reinvest proceeds from one passive real estate investment to another, you can keep punting taxes indefinitely. You can think of it as “laddering” your on-paper losses, even as you keep collecting cash flow distributions and profits properties sell.
In some cases, you get your initial investment capital back when the sponsor refinances. So you keep your ownership interest in the property and keep collecting cash flow from it, but you get your money back with no capital gains taxes. In this way, you can keep reinvesting the same capital repeatedly to earn infinite returns.
All the while, you don’t have to hassle with direct mail campaigns, property renovations, managing contractors, tenants telling you “check’s in the mail,” or building inspectors—you get the idea.
It’s how I invest currently, and these are the kinds of investments we review together every month in SparkRental’s Co-Investing Club. I don’t miss being a landlord one bit.
Keep It Simple
When you use the lazy 1031 exchange strategy, you don’t have to worry about hiring a qualified intermediary, finding a replacement property within 45 days, or closing on it within 180 days.
All you have to do is invest in a new group real estate investment within the same calendar year.
As a dad, a busy entrepreneur, and an expat living overseas, my time is my most precious commodity. I invest in both stocks and real estate passively, dollar-cost averaging both investments.
You can keep your real estate investing side business. I like my investments and tax strategies to be simple and hassle-free.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
Property Chomp’s Take:
Real estate investing offers numerous strategies to help investors avoid taxes. However, many of these strategies can be complicated and require the assistance of third parties. That’s why I prefer to use the “lazy 1031 exchange” strategy, which eliminates the need for hoops, hassles, and hiring custodians. But before diving into the details of a lazy 1031 exchange, let’s first review how standard 1031 exchanges work.
Section 1031 of the IRS tax code allows investors to participate in a “like-kind exchange,” where they swap one similar asset for another. By selling a rental property and using the proceeds to purchase another property, investors can defer capital gains taxes on the sold property. This strategy allows investors to continually upgrade their properties without ever paying capital gains taxes on the profits. However, it’s important to note that the new property must have a greater value than the sold property, and when the last property in the chain is sold, full capital gains taxes on all accrued profits will be owed unless the investor holds onto the property until death, allowing for a cost basis reset.
While 1031 exchanges can be beneficial, they also come with drawbacks and headaches. For example, investors must adhere to strict timelines. Within 45 days of selling the old property, they must declare the new property they intend to purchase as a replacement. Additionally, the investor needs to hire a “qualified intermediary” to hold the proceeds from the prior property sale, which can be costly.
That’s where the lazy 1031 exchange comes into play. When investing passively in real estate syndications, investors can take advantage of significant tax write-offs in the first few years of ownership. These upfront losses can be used to offset other passive income or capital gains on investments, such as profits from a past real estate investment sale.
For example, let’s say an investor invested $50,000 in a real estate syndication deal three years ago. This year, the property is sold, and the investor earns a $30,000 profit on top of the cash flow earned over the last three years. Instead of paying capital gains taxes on that profit, the investor can simply invest in a new real estate syndication deal within the same year. By doing so, the upfront losses shown on paper will offset the $30,000 gain, resulting in no capital gains taxes owed.
Accelerated depreciation write-offs can further enhance this strategy. There are two sources of fast depreciation write-offs: cost segregation studies and bonus depreciation. Cost segregation studies involve reclassifying portions of a commercial property into tax categories with shorter depreciation timelines. By doing so, investors can depreciate these portions over just five or seven years instead of 39 years. Additionally, bonus depreciation, which is currently available until 2027 (unless renewed by Congress), allows investors to take even more depreciation than usual.
By continually reinvesting proceeds from one passive real estate investment to another, investors can indefinitely defer taxes. This strategy allows for the “laddering” of on-paper losses while still collecting cash flow distributions and profits from property sales. In some cases, investors can even get their initial investment capital back when the sponsor refinances, allowing for the reinvestment of the same capital repeatedly to earn infinite returns.
The lazy 1031 exchange strategy simplifies the process by eliminating the need for a qualified intermediary, strict timelines, and finding replacement properties within a specific timeframe. Instead, investors only need to invest in a new group real estate investment within the same calendar year.
As a busy entrepreneur and dad, I value my time greatly. I prefer to invest passively in both stocks and real estate, using a dollar-cost averaging approach for my investments. I like to keep my investments and tax strategies simple and hassle-free, allowing me to focus on other aspects of my life.
If you dread tax season or are unsure how to maximize deductions for your real estate business, I recommend checking out “The Book on Tax Strategies for the Savvy Real Estate Investor” by CPAs Amanda Han and Matthew MacFarland. This book provides practical information to help you not only navigate your taxes this year but also prepare an ongoing strategy to make future tax seasons easier.
In conclusion, the lazy 1031 exchange strategy offers a simplified and hassle-free approach to real estate investing while still providing significant tax advantages. By investing passively and taking advantage of accelerated depreciation write-offs, investors can defer taxes indefinitely and focus on enjoying the benefits of their investments.