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.
Known as bonus depreciation, it started sunsetting in 2023 and will phase out completely by 2027. That is unless it’s renewed by Congress between now and then, which is entirely possible.
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.