Investors have plenty of options to minimize taxes on real estate. My favorite is the simplest of all: the “lazy 1031 exchange.”
It doesn’t require IRS forms, qualified intermediaries, or strict deadlines. Yet you still get to defer taxes on real estate profits.
In fact, it fits perfectly with my real estate strategy of dollar cost averaging. Every month I invest small amounts in passive real estate investments as a member of an investment club. And it keeps creating new “on-paper” losses to offset any gains.
But before getting into how this strategy differs from a traditional 1031 exchange, let’s recap the basics of how those work.
In a 1031 exchange, you take your profits from selling one property and reinvest them into a new property. By doing so, you defer capital gains taxes — you don’t have to pay them until you sell the new property.
Sounds great on paper, right? Too bad 1031 exchanges come with so much red tape and rules.
“To conduct a 1031 exchange, you have to hire a third-party qualified intermediary,” explains real estate investor Shaun Martin of WatsonBuys.com. “The QI holds your proceeds from the sold property in escrow, and files IRS paperwork for you.” That adds cost and inconvenience.
You also need to follow strict timelines. First, you must declare the intended replacement property within 45 days of selling the original property (you can declare up to three options to buy). You must then close on the new property within 180 days of the old property selling.
While it’s theoretically possible to 1031 exchange real estate syndications, that only typically works if the sponsor plans the deal specifically for a 1031 exit later. Technically, you can negotiate with the sponsor to let you invest “tenants in common” to 1031 exchange funds, but it requires a huge investment for sponsors to consider it.
Fortunately, you don’t need to hassle with any of that to get similar results.
Due to how depreciation works, you get a huge tax write-off in the first few years of a syndication investment.
And then of course you have to pay the piper when the property sells. The IRS slaps you with a huge tax bill.
So? Reinvest your funds and proceeds from the last deal into a new one.
Because you show a loss on paper (on your K-1) from the new syndication, it offsets your gains from the sold syndication. All you have to do is invest in a new syndication in the same calendar year as the old one sells.
That’s it.
If you still have a few questions, you’re not alone. It helps to understand exactly why you show a loss on your K-1 in the first few years of investing in a syndication.
When the sponsor buys a new property, they nearly always conduct a cost segregation study to accelerate the depreciation schedule.
It works like this. The building as a whole can only be depreciated over 27.5 years (residential) or 39 years (commercial). “That doesn’t leave you with much of a write-off each year,” says Ryan Greene of Total Home Supply. “But other components of the property, such as appliances, specialty plumbing, carpeting, ventilation systems, and others can be depreciated much faster: in 5, 7, or 15 years.”
That lets you speed up the depreciation write-offs. But it’s not the only way.
The Tax Cuts and Jobs Act of 2017 let investors write off far more depreciation than usual. Known as bonus depreciation, it allowed investors to write off huge losses in the first year of ownership.
Sadly for investors, bonus depreciation is sunsetting. The law phases out bonus depreciation from 2023–2027 if it’s not renewed by Congress, which might actually happen. Rocio Espinosa from PropertyShark explains: “In January, the House of Representatives passed the Tax Relief for American Families and Workers Act of 2024, sending it to the Senate, where its fate remains to be determined. If it passes, it will extend 100% bonus depreciation through 2025. That retroactively includes 2023.”
In 2015 I moved abroad, and today I invest in real estate while traveling the world. I got rid of all my rental properties and all the headaches of active real estate investments.
Buying properties takes enough work as it is, between finding deals, financing, renovations, staying on top of contractors, hassling with permits and city inspectors, marketing vacant units, collecting rents, enforcing leases, and so on. It exhausts me just thinking about it.
Add the hoops of a 1031 exchange and it just layers on more work and complications.
I value my time above all else. I want passive income and appreciation from truly passive investments. So I keep my investments and my strategy simple.
Through our Co-Investing Club, I invest relatively small amounts ($5,000) in a new real estate syndication. These new investments create plenty of K-1s reporting losses. These losses offset any gains or passive income I earn from other properties.
Once funded, I don’t have to think much about my investments. They just start earning cash flow and appreciation in the background, while I go back to hiking with my daughter or wine tasting with my wife.
To me, simpler is always better.
About the Author:
Brian Davis is a real estate investor, personal finance writer, and co-founder of SparkRental with over two decades in the real estate and finance industries. He owns fractional shares in over 2,000 units and regularly contributes as a real estate and personal finance expert for Inman, BiggerPockets, R.E.tipster, and more.
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.