Ask Brian is a weekly column by real estate expert Brian Kline. If you have any questions about real estate investing, DIY, buying / selling homes, or other housing inquiries, please send your questions to [email protected]
Question from Elizabeth in MS: Hi Brian, I have a full time job with a part time real estate investment firm next door. I rent three single family homes that I have purchased in the past eight years. I am preparing to look for a fourth rental house to buy. I decided to try a trial membership with a local investment club to do some networking and see if I can find a good deal on my next investment. In my first meeting, I chatted with a guy with a table that offered a course on 1031 Tax Exchanges. I do my own tax returns and thought all of my tax bases were covered. But I have never heard of a 1031 tax swap. At the same meeting I spoke to another guy about this tax break and he mentioned that another possibility is to invest through a retirement account. Solo 401k. At the very least, I got my money’s worth from the trial subscription. Now I would like to know more before making my next investment.
Answer: Hello, Elisabeth. Both the 1031 Exchange and the Solo 401k are powerful tax benefits, but they have limitations. Either one can work for you depending on your long term plans and where you want to go with your wallet. But first, congratulations on finding new wealth building opportunities that come with networking.
Exchange 1031 got its name from section 1031 of the IRS code. The first thing you need to know is that it requires you to sell one of your investment properties and buy another of equal or greater value. It won’t work for you if you are just planning to add another property to your portfolio. On the other hand, this could be the perfect tool if you want to do something like sell one of your homes to invest in a property that generates more income. Let’s say a duplex or a four-unit building. You can certainly go further by using a 1031 tax exchange, but anything larger than four units is considered commercial property with more complexity.
There are four variations of the 1031 Tax Exchange, so I’m only going to cover the basics here. If you want to learn more about the variations, you can take the course from the guy you met or you could probably save some money if you buy a book and speak with a real estate tax professional.
The basic idea of ââa 1031 tax swap is that when you sell a business or investment property, you have a capital gain – you owe tax on the gain at the time of the sale. Article 1031 of the Tax Code allows you to defer payment of tax on the gain if you reinvest the proceeds in a similar property as part of a qualifying “like-for-like” exchange. Your big advantage is that you can use the money you would have paid in taxes as part of your payment for the larger property. This is a tax deferral, which means you will eventually have to pay tax, but the point is, it might not be until after you die. As you continue to build your portfolio, you can defer capital gains tax if your purchases are for properties of equal or greater value. Elizabeth, the biggest inconvenience for you might be having to sell one property to buy another. It can be a deterrent if all of your properties are well managed and generating a healthy income. Another deterrent could be the fact that your goal is to own all of your properties and you don’t want to finance a future purchase for a more expensive property. In addition, one must be very aware of the strict deadlines that apply. For example, identifying potential replacement properties within 45 days of the sale of the abandoned property and finalizing the purchase of the replacement property within 180 days. If you miss any of the critical deadlines, the IRS will disqualify the 1031 exchange. The good news is that there are four variations of the 1031 exchange. You’ll want to familiarize yourself with each before making a decision.
- Delayed exchange – the most common.
- Reverse Exchange – allows you to buy the replacement property before you sell the abandoned property.
- Simultaneous swapping – not as common but can work if two investors are literally swapping properties, which was originally meant as an ‘swap’ many years ago.
- Improvement swap – also less common, but may be preferred when the investor needs to improve the new property before taking possession.
Investing in real estate with a Solo 401k retirement account is a very different animal. But investing in real estate is an extremely popular option because Solo 401k accounts are for alternative assets other than Wall Street stocks and bonds, which almost all employer-based 401k retirement accounts are limited to.
There are two basic types of Solo 401k accounts. The traditional Solo 401k uses the IRS tax code to defer taxes until withdrawals begin (usually after retirement). What is different from the 1031 exchange is that you defer your income taxes instead of capital gains tax (you can also defer capital gains tax). But again, these deferred taxes give you more money to invest and increase your income faster. The biggest hurdle is that you have to be self-employed and you can’t have employees. You can hire contract labor, but you can’t have employees directly on your payroll.
Elizabeth, you are already a real estate investor, which qualifies you as self-employed. Your rental income can be taxed deferred in a Solo 401k. What you need to know is that you will not be able to place your existing rentals in a Solo 401k. There is an IRS rule that prohibits what they call “self-operation” (there are similar rules that apply to certain family members). The concept is that you and your Solo 401k are entirely different business entities that cannot do business with each other directly. You can defer your current income taxes as contributions to your Solo 401k, but once the money is in the Solo 401k you cannot directly benefit from it until you start making withdrawals. There are a few simple rules you will need to learn about self-operation. While you cannot put your existing rentals into a Solo 401k, it is possible that your next purchase and future purchases may go into a tax-deferred Solo 401k. The key is that you must first set up the Solo 401k and name your next house after your Solo 401k. This could be a great option if you are comfortable with your current income and are serious about getting started funding your retirement account. A Solo 401k is also a great way to build wealth.
The other type of Solo 401k is a Roth Solo 401k. The same rules for own account transactions apply, but the tax structure is different. Instead of deferring your current income taxes, you pay the taxes before you make the Roth Solo 401k contribution. The tax benefit is that any earnings that increase over the years will be tax free when you start making post-retirement withdrawals. For example, the income from two rentals in a Roth 401k could be used to purchase a third (or fourth or fifth) rental home and you should never pay income tax on any of those homes. A Roth Solo 401k tends to work best for younger investors with many years to increase income and people who expect to be in a higher tax bracket upon retirement.
Elizabeth, doing your own taxes when you’re a real estate investor can be admirable, but it might not serve your best interests. You may want to work with a real estate tax professional at least every few years. Especially the years when you are going to buy or sell a property.
What other tax advantages do you want investors to know about? Please add your comments.
Our weekly Ask Brian column welcomes questions from readers of all levels of experience with residential real estate. Please email your questions or inquiries to [email protected]
Author Biography: Brian Kline has been investing in real estate for over 35 years and has been writing about real estate investing for 12 years. He also draws on more than 30 years of business experience, including 12 years as a director at Boeing Aircraft Company. Brian currently lives in Lake Cushman, Washington. A vacation destination, close to a national and the Pacific Ocean.